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CHAPTER 1
INTRODUCTION TO LIFE INSURANCE
Q1 What Is Life Insurance, Where Did It Come From, and Why Should I Care?
Life insurance is a type of insurance that pays money when someone passes away. Thatās simple. However, to understand what life insurance is today you should look at how life insurance originated. Life insurance is one of the very oldest types of insurance/financial products in existence. It stems from the old principle that if a villagerās house burned down, the other villagers would help to rebuild the house.
The first life insurance came from this concept. Then a concept known as the tontine annuity system was founded in Paris by the 17th century Italian-born banker Lorenzo Tonti. Although essentially a form of gambling, this system has been regarded as an early attempt to use the law of averages and the principle of life expectancies in establishing annuities. Under the tontine system, associations of individuals were formed without any reference to age, and a fund was created by equal contributions from each member. The sum was invested, and, at the end of each year, the interest was divided among the survivors. The last remaining survivor received both the yearās interest and the entire amount of the principal.
However, as the amount of money that people wished to be insured for increased, and the risk potential for violent fluctuations for those involved increased as well. To minimize this effect, it was necessary that the law of large numbers be applied to this situation. This is where we see the first roots of the actuarial practice. An actuary is a mathematician employed by an insurance company to calculate premiums, reserves, dividends, and insurance, pension, and annuity rates, using risk factors obtained from experience tables. These tables are based on the companyās history of insurance claims as well as other industry and general statistical data.
This is an example of the principle known as the Law of Large Numbers. This principle states that the greater the number of similar exposures (in this caseālives insured) to a peril (e.g. death), the less the observed loss experience will deviate from the expected loss experience. Basically, the more people that the risk is spread out over, the more money (premiums) will be coming in. So, when a person does die, it will not be as big of a burden to the rest of the insureds. Of course, in certain circumstances, there will not be much that can be done.
The function of insurance is to safeguard against misfortunes by having the losses of the unfortunate few paid for by the contributions of the many that are exposed to the same peril. This is the essence of insuranceāthe sharing of losses and, in the process, the substitution of a certain small ālossā (the premium payment) for an uncertain large loss. (ReferenceāBlack, H. and Skipper, K.; Life Insurance, Twelfth Edition, Prentice Hall (Englewood Cliffs, NJ), p. 18)
Life insurance, like any other financial product, is a tool to assist you in accomplishing a specific goal (or goals). As such, it will assist the beneficiary when there is an economic loss, due to the death of the insured that extends well beyond just funeral or final medical expenses. The loss of future income, due to the death of a breadwinner, can have a severe impact on the lifestyle of the surviving family members. Debt owed by the deceased may become due and payable as well as possible estate or inheritance taxes. Life insurance can create an immediate source of funds to enable the payment of these expenses and to provide a source of future income.
Benjamin Franklin helped found the insurance industry in the United States, in 1752, with the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. The current state insurance regulatory framework has its roots in the 19th century, with New Hampshire appointing the first insurance commissioner in 1851. Insurance regulatorsā responsibilities grew in scope and complexity as the industry evolved. Congress adopted the McCarran-Ferguson Act in 1945 to declare that states should regulate the business of insurance, and to affirm that the continued regulation of the insurance industry by the states was in the publicās best interest.
The purchasing of life insurance is an uncomfortable task for many people, and the image of most life insurance advisors leave something to be desired with examples such as Bill Murray in Groundhog Day and Mel Brooks in High Anxiety. Typically, there is recognition of an obligation to protect oneās dependents from the financial hardship of an untimely death, but no one likes to think about the fact that they will die someday. This is another reasonāaside from the potential discomfort of dealing with a life insurance advisorāthat can make it easy to delay and put off the decision to purchase life insurance.
Keep in mind as you go through this process that life insurance is not for you, it is for your survivors. Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income.
āAny road will get you there as long as you donāt know where youāre going.ā
āSocrates
Q2 Why Do I Need Life Insurance?
Times have changed, and the reasons people buy life insurance have grown from the original purpose. The following is a list of some of the more common reasons:
- Income ReplacementāProtect the premature death of a spouse or parent so that the loss of income is not devastating to the family.
- Payment of Outstanding DebtsāSuch as mortgages, car payments, and credit cards.
- Final ExpensesāFuneral and other administrative expenses.
- Education FundingāThe death of a parent may mean that the quality of education, intended for a child, may be out of reach.
- Emergency FundāAny adjustment expenses, such as time off work and medical and counseling expenses.
- Special Needs ChildāLife insurance provides a guarantee that the funds will be there to care for those special needs.
- Business ContinuationāTo provide funding to assist in orderly transfer of business ownership in the case of an ownerās deathālife insurance guarantees that the business is transferred as intended.
- Business InsuranceāKey Person, Executive Bonus, Split Dollar, and Deferred Compensation funded with life insurance.
- Estate TaxesāUnder current tax law, life insurance can provide liquidity at death to pre-fund the estate tax liability. This may not be necessary if the Estate Tax is permanently repealed.
- Charitable GivingāA charitable-minded client may leave a gift to a favorite organization, without significantly reducing the size of the estate, by using the death benefit to replace the value of the property gifted to heirs.
- Equalizing InheritanceāProvides additional liquidity to assist in providing each child with equal shares of their parentsā assets.
- Income In Respect of a DecedentāPeople die owning assets that have not yet been taxed; these taxes then become the obligation of the beneficiary. Life insurance provides liquidity to assist in the payment of these taxes.
- Second MarriagesāThere can be conflict when a parent with children remarries. Life insurance on the parent provides the new spouse financial security from the insurance coverage. At the same time it allows the children to receive the parentās estate immediately. This can avoid unwanted animosity between the children and the new spouse and allow them to live in harmony.
Please note that that life insurance is commonly used for business reasons. Further information is in Question 129.
Is proper planning for everyone?
As the famous saying goes, only two things in life are certain: death and taxes. This table looks at the fact that no matter how rich and famous you are, you should always expect the unexpected.
Q3 How Much Life Insurance Do I Need?
This is an excellent question to which there are as many answers as there are people to ask. Every advisor, financial columnist, and relative has a formula that they consider the best. This section is designed to present the various methods used, as well as the pros and cons of each method ranging from the simple to the extremely complex. As these issues deal with how to value a life, it is indeed a very complex proposition.
The method that makes the most sense to you is probably the one that may work the best for you. No method is perfect, as you are trying to hit a moving target. Life brings many changes and your needs will change with them. The more assumptions you make, the more complex youāll make your planning, and the more chances there are that something will not work as planned. This does not mean that you should only use the simplest methodsāit is to give you a concept of why it is important to actively participate in all of your planning, fully understand it, and constantly monitor it. After all, it is your money. Remarkably, the simplest formulas can often be the best.
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