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Ten Minute Lesson on Life Insurance

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(Type in the amount of coverage you desire. We'll assume $500,000 for this example.)

There is the “minimum one can pay” for a given amount of insurance coverage for a specific age and the “maximum one can pay”. Who determines the minimum? The Insurance Company. At the other end of the spectrum is the “maximum one can pay” for a given amount of coverage. And who determines that... besides you? The government. The fact that the federal government limits how much money one can put in a life insurance policy says what about it? It must be... good. More specifically, it must be good in relationship to one subject: taxes. Basically the government decided the upper limit of tax advantaged growth they would allow and the policy holder still have access to the cash value. Policies outside this allowable corridor are determined to be a “Modified Endowment Contract” or MEC, which simply means the government will treat the insurance contract like they do “Qualified Plans”, with all the rules, regulations and related penalties. After we're done, you will probably know more about life insurance than most life insurance agents.

The premium amount that can be charged between the “minimum” and “maximum” are almost endless. As mentioned earlier, the insurance companies determine the “minimum”. They have actuaries that calculate the “least amount of premium” they can charge and still make a profit. They understand “opportunity cost”, which means they have factored in the time value of the premium. In the 1980’s, the government “drew the line” that determined the “maximum” amount of contributions allowable for a given face amount of coverage. They accomplished this with two laws: TAMRA and DEFRA. (Technical And Miscellaneous Revenue Act of 1988) (Deficit Reduction Act of 1984) These two laws basically said “wait just a minute”. The government cannot let people put unlimited contributions in a life insurance policy as was then allowed. Remember, there is a budget preference for plans that only postpone taxes (that includes qualified plans such as 401(k)'s, IRAs, SEP and 403(b) plans). The use of these plans could be discouraged if there was an unlimited life insurance alternative, because if people could, then they might not use qualified plan programs that are designed to defer taxes.

Let's change concepts for just a moment. What do “Qualified Plans” do? The number one response is that they “defer taxes”. If that is what you said they do, you were only half correct. They also defer the tax calculation. Perhaps a more clear word they could have used would have been postpone. Let’s say you wanted to borrow $10,000. You would ask two questions before you took the money. The first question would be “How much interest do you have to pay?” The second question would be “When do you have to pay it back?” If the lender responded by saying, “We have enough money right now and do not need any payments from you at this time, but there will come a time when we will need the money. When we know how much we need, we will be able to determine how much interest we have to charge to get the amount we need. Would you cash that check? Absolutely not! But this is exactly what we are doing with the government in “Qualified Accounts”. They are not saying “You do not owe the tax”. They are saying “You can pay the tax later”. At what bracket? That is a good question. This is not to say Qualified Plans are bad. However, it is important that you know and understand exactly what they do.

Now, getting back to insurance. Let’s assume you could pay $500 for $500,000 of insurance coverage or you could pay $10,000. Which would you choose? Being bargain shoppers, most of us would probably say $500. “Less is best” when it comes to cost. Right? Let’s say the $500 represents the “lowest premium” one can pay for $500,000 of coverage at a given age. The “lowest premium” is known as term insurance. It provides one benefit, death benefit. Term insurance offers protection for the least expensive initial cost. The best day financially, to own term insurance is which day? If you guessed “the day you die” you were not even close. The best day financially to own a “term life insurance policy” is the first day. That’s right, it is the first day you buy it. Had you purchased the policy today, received approval, signed the delivery receipt, paid the first premium and died on the way home from your agent’s office you cannot get a better return than that financially. To calculate the “rate of return” on such an event would be next to impossible. Granted, it would be hard to get people to sign up for this type of financial windfall.... but you understand the point. If the best day to own a term policy is the first day, it means that for every day you own it, it becomes worth less and less, thus costing you more and more. When determining the cost of “term insurance”, one must also factor in the “opportunity cost” of owning this product. Remember the cost is not just the amount you paid in premiums, but what those dollars “could have earned” had you not bought the coverage and taken the risk yourself - which we are not suggesting you do.

For an insurance company to talk you into putting $10,000 in a policy with an initial value at death that you could get for $500, they would have to come up with some serious benefits agreed? For any financial product you could buy, each comes with different features, benefits and also costs and restrictions.

If you could wave a magic wand, what benefits would you desire?

Would you like the cash value to grow "tax deferred" as opposed to "taxable"?

Would you want "tax-free" distributions? (This would be by access to the cash value using tax-free policy loans and withdrawals. Of course policy distributions by loan or withdrawal will reduce the death benefit and cash value and it's important to keep the policy in force to avoid income taxation.)

Would you want a competitive rate of return? (Interest rates credited to permanent life insurance policy cash value are often very competitive with other interest earning accounts.)

Would you want to be able to make large contributions? (Contributions to a life insurance policy will depend in part upon how much death benefit you are able to buy.)

Would you like additional benefits like the ability to wave premiums, or even receive disability income if you are sick or injured, or protection if you are unemployed? (Life insurance can be customized with optional riders that can provide these other types of benefits. Riders are optional, may come at additional cost and may not be available in all states or on all policies.)

Would you want it to provide collateral opportunities? (Life insurance cash values are available collateral sources.)

Would you want the money to be safe? Would you want no loss provisions? (Certain types of life insurance, such as whole life, offer guarantees for cash accumulation, premiums and death benefit. These guarantees are dependent upon the claims paying ability of the issuing company.)

How about unstructured loan payments - where you determine the payment schedule? (You may choose to repay the loan in practically any installment manner that fits your situation. It's possible to let the loans and interest accumulate - allowing them to be paid automatically either at the death of the insured or if the policy is surrendered.)

Would you want liquidity, use and control of your money? (With permanent insurance we just nave to remember that if the policy is surrendered during the early years of the policy there are surrender charges that may be incurred.)

Would you want your premiums to be deductible? (You won't get that with a privately owned life insurance policy, although life insurance owned by a qualified plan is paid for with tax deducted dollars.)

There is one product that offers the majority of the benefits on the list - and it's "permanent life insurance".

However, not just any design will do. Life insurance policies that are "minimally funded" only provide minimum levels of benefit particularly when it comes to the ability to accumulate the cash value. Remember, the government "drew the line" that determined the "maximum" amount of contributions allowable for a given face amount of coverage. Contributions over this line create a Modified Endowment Contract or "MEC". However, contributions made right up to this lie create a different type of "MEC" that we call the Maximum Efficient Contract. "What you need to understand is that as you move from the highest possible premium to the lowest, the value of the benefits decrease. The higher the premium, the higher the level of each benefit received, until you reach the MEC line. Up to that line, but not over, is the position that may provide the greatest amount of benefits a life insurance contract has to offer, while still allowing liquidity, use and control of your money.

There are circumstances where one needs only death protection and a low, “level premium” is desirable. In this situation, or when coverage is needed for a “short period of time”, “term coverage” may be the best immediate temporary solution. If, however, you are looking for a place to accumulate money that provides the highest level of benefits mentioned at their maximum level, “permanent life insurance” can be a solid choice. Currently we know of no other financial product that offers these same benefits at the same level.

Insurance companies limit the amount of death protection one can purchase, known as the “face amount”, based on:

•present age,

•mortality costs,

•current assets, and

•income.

How much insurance should you have? Most of us assume this is a needs discussion. This discussion is really about “wants” not “needs”. There is no one wise enough to determine what one needs, since the very thought of “need” represents the least amount. A least analysis approach would be to assume that if one purchased the least amount of coverage and died that amount would be adequate. It would be hard to find anyone, who has been successful at anything, who began by calculating the least they had to do to make it. Life insurance should be considered a “want” product. You decide what you “want” to happen then it can be determined how much coverage it will take to accomplish what you want. Life insurance can provide the immediate funds to guarantee that what you want to happen, will happen in the event of your death.

Make sure your policy will ensure that what you want to happen - WILL happen!