Life Insurance: Preface
Introduction to Life Insurance
Types of Life Insurance
2 TYPES OF LIFE INSURANCE AND ANNUITY
To the public and perhaps inexperienced insurance intermediaries, there must seem to be a bewildering variety of life insurance contracts. Certainly, it is a sophisticated and well-developed market, but a few basic guide rules should prove helpful:
(a) Basic functions: it is good to distinguish the various products offered by life insurers by what the products seek to do. Another way of thinking about that is to ask the question: "Under what circumstances is/are the benefit(s) payable?” Some basic formats are:
(i) payment on death only if it occurs during a specified period;
(ii) payment on death at any time;
(iii) payment on a specified date or on earlier death.
(b) Basic variables: some additions/modifications to the above are:
(i) the type of policy (called the plan) may be convertible, i.e. able to be changed into a different plan, at the policyowner's option;
(ii) renewable, if originally for a limited time period (e.g. five years);
(iii) Par or Non-par: see 1.3.1b(a);
(iv) various Riders, i.e. endorsements, may be added to the policy, either to provide additional cover or to make certain provisos.
(c) Basic questions: much heartache and misunderstanding in the whole business of life insurance selling would be avoided if insurers and insurance intermediaries clearly put the following two questions to potential policyowners (and of course acted in accordance with the answers):
(i) "What do you want the insurance to do for you?", i.e. what is it for?
(ii) "How much premium are you able and willing to pay?", i.e. what can you afford?
Note: The other basic question “How much life insurance do you need?” is of course important, but this is usually answered by the insurance intermediary rather than the applicant.
Given these important preliminaries, we may now think about specific policy types. We should just say, however, that we shall only be considering an outline of the various covers, so that you may be in a position to identify and broadly distinguish the various types of plan available. Professional skill and discrimination can only be obtained through experience.
2.1 TRADITIONAL TYPES OF LIFE INSURANCE
These will consist of the three basic formats mentioned in (a) above, although there are many possible variations and combinations of the different types of cover. The major traditional types we shall consider are as follows:
2.1.1 Term Insurance
Such a policy plan provides cover for a specified period or term only, and may also be described as temporary life insurance. The policy benefit is only payable if:
(a) the life insured dies during the specified period, or term; and
(b) the policy is valid (in force) at the time of death.
In the great majority of cases, term insurance plans run their course without a claim. For these reasons, it is the cheapest form of cover available (but, of course, its limitations must be understood).
In theory, the term could be for any period of time, even a few hours to cover an aircraft flight, for example. In practice, it is rare to find a term insurance for a period of less than one year.
2.1.1a Level/Decreasing/Increasing Term Insurance
(a) Level term insurance: this policy plan is perhaps the most popular term insurance. It involves a level death benefit throughout the policy period. In the event of death during the
term, the face amount (also known as face value) of the policy is payable. The level of annual premium usually remains the same throughout the policy term.
Popular largely because of its simplicity, this is a useful answer to a temporary need which neither increases nor decreases to any significant extent over the period of time involved (perhaps a loan which is not being repaid by instalments).
(b) Decreasing term insurance: under this plan, the death benefit decreases annually, or at other specified times. The level of annual premium usually remains the same throughout the policy term. Because the benefit is continually decreasing and is payable only on death during the term, this is the cheapest form of life insurance available. It is particularly suited for a temporary need which is reducing. Some typical examples are:
(i) Credit life insurance: designed to pay the balance of a loan direct to the lender should the borrower die before a full repayment of loan has been made. This plan is usually sold to lending institutions on a group basis to cover the lives of their borrowers.
(ii) Family income insurance: perhaps linked with another policy plan which provides a lump sum payment on death, a family income plan provides a stated monthly death benefit
payable to the beneficiaries for the remainder of a specified period (the total amount payable (i.e. monthly benefit x number of payments) is therefore decreasing as time goes by). Suppose a life insured under a 5-year family income plan for a monthly benefit of $1,000 dies at the end of year 4. The plan will pay the beneficiary 12 monthly payments of $1,000 each, totalling $12,000. On the other hand, a death at the end of the 50th month will mean 10 monthly payments of $1,000 each, totalling $10,000.
(iii) Mortgage redemption (or ‘mortgage protection’) insurance: a typical mortgage loan is reduced by monthly or other periodic payments. Mortgage redemption insurance is a decreasing term insurance designed to provide an amount of death benefit which corresponds to the decreasing balance of a mortgage loan. At any rate, the initial face amount and the subsequent reduced amounts are set at the time of purchase on the basis of the plan of repayments. Such a plan may be on a joint-life basis (e.g. husband and wife), the benefit being payable when the first life dies. (The major differences between mortgage redemption insurance and credit life insurance are that (a) the former insures the interests of the mortgagors (who may sometimes be required by the mortgagees to name the mortgagees as beneficiaries) whereas the latter insures the lenders’ interests, and (b) the
former is a benefit insurance so that claims will still be payable even if at the time of death the debt has already been paid off whereas the latter is normally an indemnity insurance.)
Note: The above form of cover must not be confused with Mortgage Indemnity Insurance. This is quite different, being an insurance for banks and similar lenders. It covers the possibility of non-repayment of mortgage loans, where the mortgaged property has to be sold in adverse market situations, thereby resulting in a loss to the bank, etc.
(c) Increasing term insurance: this plan, as the name suggests, involves a death benefit which increases annually or at other intervals. The increases may be at a fixed percentage, or in line with an agreed index (e.g. Consumer Price Index). The basic idea is to keep the benefit in line with the value of money, especially in case of inflation. The premium generally increases in line with the increases in the level of benefit.
2.1.1b Renewable/Convertible Term Insurance
(a) Renewable term insurance: at first sight, this seems to be a contradiction, because a term insurance is for a fixed period, and this extends the period. The key point, however, is that the right to renew the policy is without submitting evidence of insurability (health) and the premium for the further period is increased to reflect the increased age of the life insured. (The new premium is said to be based on the attained age.)
Because such a plan can involve anti-selection (see 1.3.2a(c)(ii)), there may be some limitations applied, such as:
(i) renewals may only be for equal or smaller face amounts;
(ii) the number of renewals permitted may be restricted (e.g. three times);
(iii) premium rates may be higher than those for non-renewable policies.
Frequently, one-year term policies are made renewable, either by a basic policy provision or a rider. These have the obvious name Yearly Renewable Term (YRT) or Annually renewable Term (ART) insurance.
(b) Convertible term insurance: such a plan includes a conversion privilege, which gives the policyowner the right to convert (change) the policy to a permanent plan without evidence of insurability (health). If this privilege is exercised, the premium for the wider plan must be calculated on the basis of the standard rate for such a plan based on the attained age of the life insured.
Because anti-selection is again a possibility with these plans, there may be restrictions:
(i) conversion may not be possible beyond a certain age (say 55 or 65);
(ii) conversion may not be possible after the policy has been in force for say 50% of its specified term (or a specified number of years);
(iii) the face amount of the new plan (permanent insurance) will be limited to that for the term insurance (probably less after the term policy has been in force for some specified time).
2.1.2 Endowment Insurance
An endowment plan provides for the payment of the face amount at the end of a specified term or upon earlier death. Should the life insured survive the term, the policy is said to mature. Thus, a claim may arise under such a plan either by death or maturity. As with a term insurance, the description of the policy must include reference to the number of years of the term involved, e.g. a 20-year endowment provides for payment of the face value (also known as face amount) after 20 years (on maturity) or upon earlier death. Features to be noted with this plan are:
(a) Premiums: are not cheap, since under normal circumstances a claim must arise not later than the specified number of years in the future; premiums are level, normally paid annually, although single premium endowments are possible;
(b) Technically: the plan is a combination of a term insurance and a pure endowment for equal amounts. (A pure endowment is a contract under which the benefit is only payable if the life insured survives the term);
(c) Par or non-par: such a plan may be on a participating (with-profit) or non-participating (without-profit) basis, at an appropriate premium;
(d) Popularity: because in principle such a plan provides the best of both worlds (premature death protection and personal savings for the life insured if the policy matures), these have an apparent attraction. However, probably because of the relatively high cost of premiums, such plans do not have great popularity here, or in many other markets at present.
2.1.3 Whole Life Insurance
Such a plan, quite literally, involves a policy that is designed to last the whole of one's life (sometimes it is called whole of life insurance). The fundamental feature is that the face amount is paid on death, whenever that occurs, and not before. Such policies, therefore, may be in existence for many years, even several decades. The relevant features to note are:
(a) Premiums: are level, but may be subject to different provisions, including:
(i) payable throughout life: in which event the policy may be called a straight life insurance, or a continuous premium whole life policy;
(ii) payable for a limited period: the policy may specify a number of years, after which no more premiums are payable, although the benefit is not paid until death takes place;
(iii) premium subject to an age-related limitation: instead of specifying the number of years, the policy may stipulate a certain age (say 65) after which no more premiums are required. As with (ii) above, no further premiums are payable if death occurs before the specified
(b) Par or non-par: either form of cover is permissible;
(c) Variations: many variations are possible, such as premiums which increase, or face amounts which change, at specified times during the policy's life, to cater for different needs as time goes by. One such variation is called a graded-premium policy, where the premium increases (against a level face amount) on a regular basis, say every three years, until it reaches an amount that becomes the level premium for the rest of the life of the policy.
2.2 NON-TRADITIONAL TYPES OF LIFE INSURANCE
Life insurance, more or less in its present form, has been practised for approximately 400 years. During that time, the basic policy formats have become very established and they still form a practical and useful role in providing this important form of cover. However, the pattern of economic and social life does not stand still and new products have been developed, often providing a more flexible approach to life insurance cover and associated investment. We look at two such examples.
2.2.1 Universal Life
In an attempt to provide greater consumer choice and flexibility, this product has been developed. It has been well described as a life insurance contract which:
(a) is subject to a flexible premium;
(b) has an adjustable benefit;
(c) has an “unbundled” pricing structure; and
(d) accumulates a cash value.
We examine these and other features of this innovative product:
(a) Flexible premium: subject to certain limits, the policyowner may pay more or less than the premium stated in a given year, after the first year. At his option, he can even omit premium payment for a particular year (again subject to certain conditions). Of course, the amounts of coverage and cash value depend on how much premium is paid.
(b) Adjustable benefit: subject to certain limits, the death benefit purchased may be increased or decreased, although proof of insurability may be required for an increase in benefit.
(c) “Unbundled” pricing: the insurer separates and individually discloses, both in the policy and in an annual report (see (f) below) to the policyowner, the three basic pricing factors, i.e.:
(i) the pure cost of protection (covering the death risk);
(ii) interest; and
(iii) expenses. (The calculation of life insurance premiums includes an item for expenses, called loading (see 1.3.1a(c)). Normally this is not disclosed to the policyowner, but with universal life insurance the expenses and other charges element is specifically disclosed to a purchaser.)
(d) Cash value: the intention is that the policy should acquire an increasing cash value. This of course is heavily influenced by the amount of premiums paid by the policyowner. After the first premium payment, additional premiums (subject to an individual limit) can be paid at any time. These, with interest earnings, are added to the cash value after the deduction of:
(i) a specified percentage expense charge; and
(ii) the pure cost of protection (deducted monthly).
(e) Death benefit: according to the plan the policyowner chooses, this may be a face amount plus the cash value, or the face amount only. For a given face amount and given premium amounts, the former option will mean a lower rate of accumulation of cash value because the insurer needs to be compensated for running a risk of paying out a higher amount of death benefit.
(f) Annual report: each year the policyowner receives a report which shows the status of the policy. The information given includes:
(i) the death benefit option selected (see (e) above);
(ii) the specified amount of insurance in force;
(iii) the premiums paid during the year;
(iv) the expenses deducted during the year;
(v) the guaranteed and excess interests earned on the cash value;
(vi) the pure costs of insurance deducted;
(vii) policy loan outstanding;
(viii) cash value withdrawals; and
(ix) the cash value balance.
It will be seen that this is a sophisticated product, allowing great choice to the policyowner to adjust his insurance according to his needs and financial resources as time goes by. Insurance intermediaries are advised to consult the insurers on local forms of this modern insurance plan.
2.2.2 Unit-Linked Long Term Policy
Also known as “linked long term policy” and “investment-linked long term policy”, the unit-linked long term policy is one whose value is directly linked to, or directly reflects, the performance of the investments that have been purchased with the premiums paid. This may be achieved by formally linking the policy value to units in a special unitised fund run by the insurer, or to units in a unit trust. The value of the units is directly related to the value of the underlying assets of the fund or unit trust. Because of such linkage, the policy value naturally fluctuates according to the overall movements of those assets.
2.4 GROUP AND INDIVIDUAL INSURANCE PLANS
The majority of the plans we have considered so far have been with applications for the insurance of individuals, either insuring themselves or another person. This remains a key element in the field of life insurance, but group insurance is playing an increasing role. This is especially so with employee benefit plans, where an employer provides a form of life insurance, often as an additional benefit supplementing salaries and wages. Again, this is a complex area, but certain features we may note:
(a) Basic difference: the most obvious difference between individual and group insurances is that the latter covers a number of people under a single policy. Sometimes this is called a master group insurance contract.
(b) Contracting parties: these are the insurer and the group policyholder, usually an employer, but possibly a club or other organisation insuring its members. The persons within the group who are covered may be referred to as group insured or sometimes group life insured or persons insured.
(c) Different plans: plans may be contributory (where the employees or other persons insured pay a share of the premium) or non-contributory (where individual members do not contribute towards the premium).
(d) Eligible groups: usually group insurance concerns a single employer, covering his staff members (called a ‘group’), but the members of association groups (i.e. members of clubs, trade unions, sports associations, etc.) formed for a purpose other than purchase of insurance could equally be considered eligible. Besides, multiple-employer groups (consisting of the staff members of different companies) may participate in a single plan.
(e) Underwriting: doing business "in bulk" means that the high degree of underwriting attention applicable to individual insurance is neither possible nor necessary. Detailed individual information is usually not required with group plans.
(f) Individual eligibility: eligibility is usually decided by the employer, and the usual criterion for admission to group coverage is known as an actively-at-work provision. This requires that the individual was not only employed, but also at work (not ill or on leave) when coverage became effective.
(g) Coverage declined: an eligible person (particularly with contributory schemes) may initially decline coverage. Should that person change his mind later, evidence of insurability may be required (to counteract anti-selection).
(h) Termination of cover: for individual persons insured, their cover may terminate upon ceasing to be eligible (leaving the employer or group) or failing to pay any required premium. Some plans allow individuals to convert their previous group cover into individual coverage, often without proof of insurability but normally within a specified time period.