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Insurance is an important aspect of financial planning and risk management. It provides individuals and businesses with protection against potential losses, such as financial loss due to death. In this blog, we will explore the basics of insurance, with a specific focus on life insurance. We will discuss the terms commonly used in the insurance industry, the different types and classifications of life insurers, the application and underwriting process, and the various types of life insurance policies. By understanding these concepts, you will be equipped to make informed decisions about your insurance needs.
Understanding Insurance Terms
Before we dive into the specifics of life insurance, it is important to familiarize ourselves with some key terms used in the insurance industry. These terms will help us better understand the concepts discussed throughout this blog.
Life Insurance
Life insurance is the transfer of the possibility of a loss from an individual to an insurance company. In other words, it is a contract between an individual (the insured) and an insurance company (the insurer), where the insurer promises to pay a financial benefit upon the death of the insured. The purpose of life insurance is to provide financial protection and stability to the insured’s beneficiaries in the event of their death.
Risk
Risk is the term used to describe the chance or uncertainty of loss in life insurance. This loss is usually a financial loss due to death. There are two types of risk: speculative risk and pure risk. Speculative risk is the chance of either a gain or a loss, such as gambling or buying a lottery ticket. Speculative risks are not insurable. Pure risk, on the other hand, is a risk that can only suffer a loss. Only pure risks are insurable.
Peril
A peril is the cause of a loss in the case of life insurance. In this context, death is the peril. The death of the insured is what leads to the loss of financial stability for the insured’s beneficiaries.
Hazard
A hazard is any condition or situation that will increase the possibility of a peril occurring. When we view death as the peril, some examples of hazards include driving recklessly or refusing to treat a serious health condition. These actions increase the likelihood of death, which is the peril in the case of life insurance.
Indemnity
Indemnity means to make whole or to restore. In the context of life insurance, it refers to the insurer’s promise to restore a policy owner who has suffered a loss to their original financial condition. The purpose of indemnity is to provide financial compensation to the policy owner, but not to profit from the loss.
Insurer
The insurer is the company that issues the life insurance policy. They are responsible for providing the promised financial benefits in the event of the insured’s death.
Producer or Agent
A producer or agent is the person who solicits and sells insurance. They play a crucial role in the insurance process by delivering policies, collecting premiums, and representing the insurer. To conduct business, a producer must hold a license in the state where they operate.
Insured
The insured is the person whose life is covered by the insurance policy. They are the individual for whom the financial benefits will be paid upon their death. In many cases, the insured is also the policy owner, as they purchase insurance on themselves.
Policy
A policy is a legally binding contract between the policy owner and the insurer. It outlines the terms and conditions of the insurance coverage, including the amount of coverage, the premium cost, and the beneficiaries who will receive the death benefit.
Premium
Premiums are the payments made by the policy owner to the insurer to keep the policy in force. The premium amount is based on various factors, such as the insured’s age, health, and the amount of coverage.
Beneficiary
The beneficiary is the person or persons named in the policy to receive the death benefit when the insured dies. They are the individuals who will receive the financial benefits provided by the insurance policy.
Face Amount
The face amount is the amount that will be paid to a beneficiary upon the death of the insured or maturity of the policy. It is also sometimes referred to as the face value, death benefit, or policy proceeds. The face amount is determined at the time the policy is issued.
Types and Classification of Insurers
Life insurers can be classified in several different ways, based on how they are formed, their authorization to do business, and where they are located. The two main types of insurers are stock insurers and mutual insurers.
Stock Insurers
Stock insurers are owned by shareholders who buy shares of stock in the company. These shareholders share in the profits and losses of the company. Stock companies issue non-participating policies, which means the insured does not share in the profits of the company.
Mutual Insurers
Mutual insurers are owned by their policy owners. Any earnings not used to pay the expenses of the company are returned to the policy owners as policy dividends. Mutual insurers issue participating policies, which pay dividends when there is a surplus of funds. These dividends are a return of excess premium paid by the policy owners and are not taxable.
Authorized Insurers
An authorized insurer has complied with the legal and financial requirements to be licensed in a particular state. They have obtained a certificate of authority, which allows them to conduct business in that state.
Non-Authorized Insurers
A non-authorized insurer is not licensed to transact business within a particular state. They have not obtained a certificate of authority and are therefore not legally allowed to conduct business in that state.
Domestic, Foreign, and Alien Companies
Insurers can also be classified based on their location. A domestic company is a company incorporated under the laws of the state in which it is located. A foreign company is a company doing business in a state other than the one in which it is incorporated. An alien company is a company incorporated under the laws of a country, state, or territory outside of the United States.
The Application, Underwriting, and Delivery Process
The process of taking an application, underwriting a policy, and delivering the policy has several steps. Before a life insurance policy can be issued, the potential risk must be reviewed and classified by the insurer. This is done through a process called underwriting.
Underwriting
Underwriting is the selection, classification, and rating of risks by an insurance company underwriter. The underwriter determines if an applicant is insurable and assigns a risk classification. The premium charged for the policy is based on the risk classification.
Insurable Interest
One of the main purposes of underwriting is to protect the insurer against adverse selection. Adverse selection is the tendency of those who are poor risks to buy or continue insurance more so than those who are in good health and do not seek insurance. One of the most important factors in underwriting is insurable interest.
Insurable interest means that the person purchasing the policy must be in a position to lose something of financial value if the insured should die. An applicant has insurable interest in their own life, but they may also have insurable interest in a spouse, child, or parent. Insurable interest may also exist between a creditor and a debtor, between an employer and a key employee, or between business partners. Insurable interest must only exist at the time of the application, not at the time of death.
The Application
The underwriting process begins with the producer, who serves as the field underwriter. The producer meets with the proposed insured and completes the application. The application is the first and best source of information for the underwriter. It becomes part of the policy contract and is the basis upon which the company will accept or decline the risk.
The application consists of three parts: general information, medical history, and the agent’s report. The general information section includes details about the proposed insured, such as their name, address, date of birth, marital status, occupation, income, and named beneficiaries. The medical history section contains questions about the proposed insured’s current health status and personal and family medical history. The agent’s report consists of personal observations about the proposed insured made by the producer.
Representations, Warranties, and Concealment
Statements made by an applicant on a life insurance application are considered representations. These representations are true and accurate to the best of the applicant’s knowledge. A warranty, on the other hand, is a statement that is guaranteed to be true in all respects. Statements on life insurance applications are considered to be representations and not warranties.
Concealment refers to the failure to fully disclose all known facts on an application. For example, a proposed insured may not lie when answering one of the medical questions, but they might not tell the whole truth. If the concealment is material to the risk, meaning the insurer’s decision about coverage would have changed, then the policy may be voided.
Disclosure Requirements
Most states require that the producer present the applicant with certain documents, including a buyer’s guide and a policy summary, at the time of application but no later than the time of policy delivery. A buyer’s guide is a generic publication that covers the different types of life insurance in language that the average consumer can understand. A policy summary lists specific information about the policy being purchased by the applicant.
Additionally, the producer may be required to obtain the applicant’s consent for certain disclosures, such as medical records authorization, HIPAA disclosures, and AIDS/HIV disclosures. These disclosures are necessary to obtain the underwriting information needed by the insurer.
Policy Delivery
Once the application has been completed and signed by the producer, the applicant, and the insured (if different from the applicant), the producer collects the first premium and sends it along with the application to the insurer. If the first premium is collected with the application, a conditional receipt is issued to the insured. This receipt makes the coverage effective on the date of the application or the date of the medical exam, whichever is later.
After the underwriter has reviewed the application and other underwriting information, the insurer issues the policy. The policy is then delivered to the policy owner by the producer. This provides the producer with an opportunity to further explain the coverage and provisions of the new policy. If the first premium was not collected with the application, the agent may need to obtain a statement of good health from the insured. This statement confirms that the insured’s health has not changed since the time of application.
Types of Life Insurance Policies
Now that we understand the basics of insurance, the underwriting process, and the delivery of the policy, let’s explore the various types of life insurance policies available.
Term Insurance
Term insurance is the most basic form of life insurance. These policies offer coverage for a specified period of time and expire at the end of that time. Term policies can be for 1, 5, 10, 20, or even 30 years. They pay a death benefit or mature only if death occurs during the policy term. Term insurance is the least expensive type of coverage because it does not build cash value.
There are three main types of term insurance: level, decreasing, and increasing. Level term insurance maintains the same face amount or death benefit for a specified period of time. Decreasing term insurance, on the other hand, has a decreasing face amount over time, but the premiums remain the same. This type of insurance is commonly used to protect a mortgage or loan, as the face amount decreases as the loan balance is paid down. Finally, increasing term insurance has an increasing face amount over time. It is often used as a rider to increase coverage on a base policy to offset inflation.
Many term policies also offer two options at the end of the policy term: renew or convert. A renewable option allows the policy owner to renew the policy before the end of the term without providing proof of insurability. A convertible policy allows the policy owner to convert or change a term policy to a whole life or permanent plan without proof of insurability. The cost of the new policy will be higher since whole life is more expensive and the cost is based on the insured’s attained age.
Whole Life Insurance
Whole life insurance, also known as permanent insurance, provides both a living benefit in the form of a savings element and a death benefit. A whole life policy remains in effect until age 100 as long as the premiums are paid and the policy remains in force. Whole life policies build cash value, which grows tax deferred until it is withdrawn. The cash value can be borrowed against, but interest must be paid. Whole life policies mature or endow when the insured reaches age 100. At that point, the cash value of the policy is paid to the insured. Whole life policies provide either the death benefit or the cash value, but not both.
There are different types of whole life policies based on the premium payment period. Straight life policies have premiums paid until age 100, also known as continuous premium. Limited pay whole life policies have premiums paid for a specified amount of time or to a certain age, but coverage remains in effect until age 100. Single premium policies have the entire premium paid up front in one lump sum.
Universal Life Insurance
Universal life insurance is a combination of term life and cash value invested at a guaranteed minimum interest rate. It is considered whole life because it lasts until age 100. The premiums paid are combined with the interest earned to first pay for the insurer’s cost of doing business and then the cost of the term policy. Any money left over becomes the cash value of the policy. Universal life policies offer flexibility in premium payments and the death benefit.
Variable Life Insurance
Variable life insurance consists of both permanent coverage with a guaranteed minimum death benefit and a cash value invested in common stock. The cash value is not guaranteed because it can go up or down depending on the fluctuations of the stock market. Variable life policies must be kept in a separate account by the insurer since the money is invested in stocks and bonds. Agents selling variable life insurance must hold both an insurance license and a securities license.
Equity-Indexed Life Insurance
Equity-indexed life insurance is whole life insurance that is linked to a public index, such as the S&P 500 or Dow Jones Industrial Average. It has a guaranteed minimum interest rate to guard against downturns in the market. It has the potential to grow faster if the market is doing well. Equity-indexed life insurance is considered a whole life insurance policy, and it can be sold with just a life insurance license.
Specialized Policies or Combination Policies
Specialized policies or combination policies consist of many of the features discussed above in term and whole life policies, but they are used for very specific needs. For example, a joint policy covers the lives of two or more people and is often called a first-to-die policy. These policies pay when the first insured dies and then terminate. Survivorship or last-to-die policies cover two or more people and pay only after the second or last insured dies. These policies are frequently used with large estates for tax purposes since death benefits are not taxable to the beneficiary. Juvenile life policies are written on the life of a child within certain age limits, and modified endowment contracts are whole life policies that have lost the tax advantages of regular life insurance policies.
Group Life Insurance
Group life insurance covers a number of individuals under one policy. Many people have group life insurance through their employers, where the employer is the policy owner. Group insurance costs less than individual insurance because of reduced adverse selection and reduced administrative costs. Group insurance can be contributory, where the cost is shared between the employer and the employees, or non-contributory, where the employer pays all of the premiums. Group life insurance also offers conversion privileges, which allow members of a group to convert their group coverage to individual coverage without providing evidence of insurability.
Credit Life Insurance
Credit life insurance is life insurance issued on individuals who owe money. It guarantees that if the individual becomes disabled or dies, the balance of the debt will be paid. Credit life insurance is usually written on a group basis and is often treated as decreasing term insurance since the amount owed decreases over time as payments are made.
Conclusion
Life insurance is an important tool for financial planning and risk management. It provides individuals and businesses with protection against potential financial losses due to death. Understanding the basics of insurance, the underwriting process, and the different types of life insurance policies is crucial in making informed decisions about insurance coverage. By having the right coverage in place, you can ensure the financial stability and well-being of your loved ones in the event of your death. Take advantage of the support system provided by insurance professionals to help you navigate the complexities of the insurance industry and find the right policy for your needs.
