This series of article address life insurance issues from many perspectives. The series comprises the following parts:
Most common folks consider life insurance as a luxury item for the wealthy and the associated insurance premium as an unnecessary expenditure. This perception is especially strong among young people in their 30’s when they are energetic, mobile and self-proclaimed to be indestructible. However, there are other angles which may change your mind for life insurance.
To understand the purpose of life insurance, we need to keep the following important points in mind.
For example, a young couple in their 20’s or 30’s is working diligently to accumulate cash for a down payment of their dream home. If one of the spouses passed away unexpectedly due to an accident or an acute critical illness, their plan of living happily together in their dream home is scattered.
With only one income, the dream of owning a home may become an unrealistic expectation. If the deceased spouse has adequate life insurance, the death benefit of the insurance policy may help the surviving spouse to partially fulfill the dream of owing a home. This situation is even more acute for a single income family where the surviving spouse stays home with an infant.
For young men or women whose parents rely on them as their providers, their premature death may create financial hardship for the parents. Government subsidies or welfare may not provide an adequate safety net during their retirement. The death benefit of a life insurance would certainly provide some financial assistance.
Most couples in their 40’s may have owned a home but have a significant outstanding mortgage balance. They need both incomes to payoff the mortgage. A premature death of one spouse would be devastating for the surviving spouse. Besides the grief, the surviving spouse may have a tough time in meeting the future mortgage payments.
If they have small children, their livelihood may also be in jeopardy. If the deceased spouse has adequate life insurance and the surviving spouse is the beneficiary, the surviving spouse may use the death benefit to payoff a large portion of the outstanding mortgage balance so that the remaining mortgage payments after re-financing would become manageable.
The surviving spouse may also use a portion of the death benefit to set up a trust account for the children’s future education expenses. In summary, the death benefit may serve as a safety net for the surviving spouse and children or buys some time for the family to handle the adversity.
For couples in their 50’s, they should have paid down a significant portion of the initial mortgage balance and the future mortgage payments are manageable. Their biggest asset is probably their home. For couples who are sophisticated investors, they may also own stocks, mutual funds or participate in retirement income schemes such as MPF.
For couples who believe in buying “bricks” and prefer to invest in real estate market, they may continue to purchase houses/apartments and incur another layer of mortgage. For other couples who want to diversify, they may prefer to invest in the equity market by opening stock accounts with licensed brokers or invest in the equity market using life insurance and annuity contracts. The accumulated amount in their life insurance policies or annuities may supplement their retirement benefits from other retirement schemes so that they can live comfortably and independently during their golden years.
For couples who are in their 60’s, their children are adults and the needs to protect them from premature death have subsided. Many of them want to help their grandchildren on the college expenses. By naming their grandchildren as beneficiaries of a life insurance policy, the grandchildren can directly receive the benefits without incurring extra costs.
For couples who are in their 70’s, estate planning is an important consideration. This is especially true for couples living in a jurisdiction where estate tax and/or inheritance tax is applicable. If they do not want the government takes a large bite on the estate, they may use a life insurance to pay for the estate tax or inheritance tax so that the entire estate can be passed to their loved ones.
As we see from the examples above, life insurance is a risk management tool for people in all ages and it is a necessity rather than a luxury item.
Please keep in mind that no one can maintain his health status permanently as if he is in his 30’s. It is just a matter of time that his health will deteriorate due to aging. If one misses his opportunity to secure a preferred status in a life insurance application when they were young and healthy, he may be rated as either standard or substandard and pay higher premium when he applies for a life insurance in his later age.
Life insurance industry offers many types of life insurance products to their customers based on the perceived market needs. The types of life insurance products can be broadly grouped into the following categories:
These products may further be divided into participating (with dividends) and non-participating (without dividends). The combinations of different life insurance products and participating status could be confusing and intimidating for a layman upon choosing an appropriate life insurance product. We hope a brief explanation of these insurance products may help you through the maze.
Term insurance can be considered as a low-cost pure life insurance protection business. Policyholder is contractually obligated to submit periodic life insurance premium payments (monthly, quarterly, semi-annually or annually) to the insurance company. If the payments are interrupted for a certain defined period (e.g., two months), the life insurance company has unilateral right to terminate the term insurance policy and remit the cash surrender value, if any, to the policyholder.
Although the policyholder may reinstate the terminated policy within the grace period, the grace period is normally short (e.g., 60 days). Many term insurance products’ premiums increase with the insured’s attain age. Some companies may offer level premium term where the premiums would remain level for a specified number of years (e.g., level for the first ten policy years) but the premiums after the initial level premium period may be several times the level premium and increase with the attained age.
Term insurance is suitable for young men/women/couple because it offers life insurance protection for their loved-ones while maintaining the premium cost low. Most term insurance policyholders maintain their term policies for only a limited time (e.g., 10 years) and purchase another type of life insurance before the term insurance premiums escalate to a significantly higher level. Most term insurance policies have no cash surrender value and are non-participating (i.e., provide dividends).
Whole life (WL) insurance offer both insurance protection as well as investment opportunities. Like term insurance, policyholder is contractually obligated to submit period insurance premium to the insurance company to avoid contract termination. Insurance companies also offer reinstatement of the terminated whole life policy within the grace period. Premium for WL product is generally higher than term insurance product because a portion of the premium is used for building up of the cash surrender value.
Unlike term insurance, premium for WL product is fixed for the duration of the contract and would not increase with the insured’s attain age. Thus, most WL policyholder maintains their policy for 20 or 30 years and use the accumulated cash surrender value to supplement their retirement income. For WL policies which are participating, the life insurance company may offer non-guaranteed dividends to the policyholder. The policyholder may take the dividends in cash, use the dividends to purchase additional life insurance protection or deposit the dividends with the life insurance company as a saving.
Obviously, participating WL policy has higher premium than non-participating WL policy. Term and WL insurance are popular products among traditional conservative customers.
Universal life offers life insurance protection too. Unlike term and WL, policyholder of universal life policy has the flexibility of varying the amount and timing of the contractual premium if the account value of the universal life policy is positive. However, if the policyholder does not render the required premiums to maintain a positive account value, the life insurance company may terminate the policy. Policyholder can reinstate the policy during the grace period if the account value is replenished to an acceptable level.
Universal life offers additional transparency on the operation of the policy. Premiums for a universal life policy are accumulated to an account value where the amount is accumulated with interest and decremented with cost of insurance and other expenses. The life insurance company has the sole discretion in declaring the crediting rate but the declared rate cannot be lower than the guaranteed interest rate.
As universal life offers additional flexibility in timing and amount of premium payments and the account value offers transparency on the investment results, universal life products become popular among investment-oriented customers.
The operation of variable life (VL) is comparable with universal life. The most significant difference is that the policyholder rather than the insurance company determines the investment strategy for the VL policy. The policyholder chooses whether the premiums are invested in fixed income securities, mutual funds or other available investment instruments.
The investment results, after deductions of applicable fees for cost of mortality and investment expenses, are passed to the policyholder’s account. VL is suitable for sophisticated customers who accept market risk and want to use VL as another investment vehicle for the equity market.
When it comes to deciding which product is suitable for you, you may consider asking yourself the following questions before making the decision:
Honest answers for these questions may assist you in determining which type(s) of life insurance is/are suitable for you. Please keep in mind that life insurance is not a one-size-fit-all commodity.
A life insurance product which is purchased by your neighbor/friend or is recommended by the insurance agent/broker may not be suitable for you. You are responsible for the ultimate selection which should be based only on your needs and circumstances.
This is a $64,000 question and there is no standard answer. It depends on your insurance needs and your economic means. While life insurance protects your loved ones, the protection should not come at a price to deprive your family’s living standard. As mentioned previously, we must honestly answer the questions in Part II and make your decision accordingly.
For example, you and your spouse are building your family and are preparing for a down payment of your dream home. In the interim, you also want a life insurance policy to protect your better-half from financial difficulties due to your premature death, you may consider buying a low-cost term insurance policy on yourself for a short period of time, say, 10 years, or until you and your spouse purchase the dream home. If you decease while insured, the spouse can use the death benefit proceed towards the down payment and keep the dream of owning a home.
In this situation, you may consider buying the amount of life insurance based on the target down payment. However, the amount of death benefit should not exceed three times your annual salary. Otherwise, the premium may become a distraction of your family budget.
After working for about ten years, you and your spouse become more developed in your professional careers. Having kids may also be a part of the family plan. If you and your spouse have already purchased your home, your insurance target should be protecting your family from the burden of paying off the outstanding mortgage. The insurance protection becomes more desirable if your spouse stays home. (You should be grateful and feel blessed if your spouse gave up her professional career to take care of you and the children.)
In this stage, you may consider either a term insurance or a whole life type insurance (e.g., whole life or universal life). The term insurance would be cheaper for providing a short-term need. A whole life type insurance may provide a longer-term protection need as well as a saving element. The choice depends on your protection horizon and family budget. Regardless, a general rule of thumb is to obtain the life insurance amount no greater than the higher of (a) three times your annual salary, and (b) the outstanding mortgage.
Different jurisdictions have different definitions of life insurance. In North America, there are guidelines on the relationship between the life insurance amount and the premium such that the annual premium and cash surrender value cannot exceed defined percentages of the life insurance amount. Such limitations are established to avoid policyholder from using the life insurance contract as an investment contract and to evade taxation. Policyholder may use other types of insurance contracts, such as deferred annuities, to satisfy the investment needs.
In Hong Kong and China, the single premium of a life insurance policy can be as high as 90% of the life insurance amount. This type of life insurance policy is suitable for investment-oriented customers. They may not be suitable for young couple who are building their nest and are budget conscious.
For customers who are interested in this type of investment-oriented insurance product, the amount of life insurance is directly related to the customer’s investment budget. They are most common among customers with significant estates who would like to use insurance contract as an alternative investment vehicle. As there could be penalties for surrendering the policy before maturity, customers should invest in these contracts using only non-emergency funds.
Insurance is an effective risk management tool for everyone. However, individuals should purchase life insurance according to their financial needs and the premium must be within the budgeted amount. As different household has different budgetary needs, one should determine the amount of insurance based on your personal analysis/budget rather than rely on other people’s decisions.
A final word of advice: “Life insurance is not a commodity product where one size fits all. Prepare a budget before talking to an insurance agent/broker. Purchase life insurance within your economic means and never purchase life insurance amount beyond your original budget.”
Customers do not purchase life insurance straightly from life insurance companies. Instead, they normally purchase life insurance policies through the following distribution channels:
Company owned distribution agencies are subsidiaries of the parent life insurance company and the agents only sell insurance products offered by the parent company. This type of agencies was popular. As customers become more insurance sophisticated, this type of agencies has subsided significantly.
Personal producing general agencies are not subsidiaries of insurance companies. Instead, they maintain agency relationships with multiple insurance companies. Their selling agents can offer products from multiple contractually-related insurance companies. This type of insurance agencies is getting more popular as customers can compare products from different companies and shop accordingly.
In jurisdictions such as Hong Kong and some Asian countries, banks sometime also act as insurance agencies for insurance companies. This type of distribution channel is sometimes known as bankassurance. A bank may have only one agency relationship with a life company and the insurance desk of the bank offers only that company’s products to the bank’s customers. In Hong Kong, a bank may represent up to two life insurance companies.
Agencies represent life insurance companies. Brokers, on the other hand, represent the customers. Upon the inquiry from a customer, a broker collects and analysis quotes from different insurance companies according to the customer’s appetite. So, brokers generally serve the best interest of the customers. However, brokers generally only represent high net worth individuals. Agent is the distribution channel for general public. Regardless, all agents and brokers must be qualified, registered and licensed to sell life insurance in applicable jurisdictions.
Recently, IT savvy young people are apt for internet distribution channel where customer may obtain quotes from insurance companies via their website. Although the volume of business sold via internet is minimal when compared with agency and brokerage distribution channels, the trend of using internet for insurance application is undeniable.
Purchasing insurance is a major decision which may affect the financial well-being of your immediate family. It requires detail considerations from many angles such as the appropriate plan, adequate protection amount and affordability. Please do not purchase insurance from an agent/broker simply because he is a family member or a friend. You need an agent who is knowledgeable of available insurance products, experienced in designing insurance planning and has your best interest in mind.
An insurance contract contains many technical insurance terms and some of the contractual provisions may be embedded with complicated exclusion clauses. A layman may need a qualified agent/broker to explain the contractual provisions. Most governments require insurance companies to provide illustrations to demonstrate product features of the insurance contracts. In addition, all governments have regulations to prohibit predatorial selling and mandate insurance companies to treat customer fairly.
Most insurance sold via internet are simple insurance contracts such as term insurance. However, they must still comply with all insurance regulations such as illustration and treating customer fairly.
When choosing an agent/broker, the customer should also perform R&D on services-after-sale. You may not want to purchase insurance from an agent/broker who vanishes into thin air the day after the sale and only re-appears when it is time to collect renewal premiums. You need an agent/broker who is readily available to serve you because you may want to make changes to the insurance contracts or filing claims. Internet offers the advantage that the company website is always available.
A simple answer is “Yes” because we are living in the age of uncertainties.
As we progress along the various stages of life, our insurance needs also change. For example, as your economic means improve, you may increase the level of insurance protection. You may also want to change from a term insurance to a permanent whole life insurance. When you progress towards age 60, you may also consider changing your insurance policy from a life insurance policy to an investment policy for retirement.
However, you should not change your current insurance policy unless you fully understand the consequences of the change. You need to do the homework and understand the economic effects of the change. Don’t make any unnecessary change because it is fashionable or under influences from friends and family. Only make the change when it makes sense to you from financial or risk management perspectives. If you don’t understand the proposed changes, ask questions or walk away.
A few quotes from Mr. Warren Buffet may be helpful for you to choose and make changes to your insurance plan:
“Price is what you pay. Value is what you get.”
“Risk comes from not knowing what you are doing.”
“Never invest in a business you cannot understand.”
Insurance contract is a complicated contract. It is a valuable risk sharing tool for policyholders who may hedge his with insurance companies. Diligence and common sense are our most valuable guidance.