Life insurance
Life insurance is a contract in which an insurer pays a death benefit to named beneficiaries when the insured dies, in exchange for premiums. It exists to replace the economic value a person's death would remove from the people who depend on them.
A life insurance policy involves three roles that may or may not be the same person: the owner, who pays premiums and controls the contract; the insured, whose death triggers payment; and the beneficiary, who receives the proceeds. At issue, the owner must have an insurable interest in the insured — a genuine financial or familial stake — which prevents the policy from being a wager on a stranger's life.
Policies divide into two broad families. Term life covers a stated period, pays only if the insured dies during that term, and builds no savings element, which makes it the least expensive coverage per dollar of death benefit. Permanent life — whole life, universal life, and variable life — covers the insured for life and accumulates cash value the owner can borrow against or surrender. Whole life fixes the premium and guarantees cash value; universal life allows flexible premiums; variable life invests cash value in separate account subaccounts, shifting investment risk to the owner.
The tax treatment is a large part of why the product is used. Death benefits paid to a named beneficiary are generally received income-tax free, and cash value grows tax-deferred. Policy loans are not taxable while the contract stays in force, but a surrender produces taxable gain to the extent proceeds exceed the cost basis, and a policy classified as a modified endowment contract loses the favorable treatment of lifetime distributions.
Underwriting sets the price. The insurer evaluates age, health, occupation, and lifestyle to assign a risk classification, relying on mortality tables and the law of large numbers to predict aggregate claims across a large pool.
Life insurance is tested from two directions. State life and life and health licensing exams cover contract provisions, riders, policy types, and taxation in depth, while the Series 65 treats life insurance as an investment vehicle a registered adviser must understand when evaluating a client's overall plan.
Key takeaways
- Life insurance pays a death benefit to named beneficiaries in exchange for premiums, and requires insurable interest at the time of issue.
- Term policies cover a set period with no cash value; permanent policies cover life and accumulate cash value.
- Whole life fixes premiums and guarantees cash value, universal life allows flexible premiums, and variable life places investment risk on the owner.
- Death benefits are generally income-tax free, and cash value grows tax-deferred, though surrenders can produce taxable gain.
- Underwriting assigns a risk classification based on age, health, occupation, and lifestyle.