Seeking Security

Chapter 9

Life Insurance

 

 

 

  Life insurance is the most common way to create an instant estate. Why would an individual wish to do this? To protect those who depend financially upon him or her, which is typically one’s spouse and children but may also include others under some circumstances.

 

  When a person is young, with young children, there has seldom been enough time to "save" an estate. In the early years, a family purchases their first home, buying items for the first time and learning how to control their finances. It is unusual to find a young family with a lot of money in savings. Therefore, buying life insurance makes sense. There are other reasons for buying life insurance, but this is usually the first use of it.  Life insurance should be an important part of every financial plan.

 

  Life insurance now comes in many forms aimed at many varied uses. Most Americans do own some form of life insurance. Even mortgage insurance is actually a form of life insurance.  Unfortunately, many of the families who buy life insurance buy the wrong kind. Either it does not adequately address their financial needs, or it is priced too high for the benefits received.  Insurance agents are often the only persons who can sort out the problems and correct them.  Many agents sell life insurance as a sideline never fully understanding the many aspects and variations that exist. It is becoming more common for companies to take on agents who have no background and no experience. These companies prefer to mold the agent’s lack of experience into selling one type of insurance or one variation of a product. As a result, many consumers end up with the wrong insurance. The selling agents do not mean to place the wrong products; they simply do not know any better. In these cases, it will be the professional insurance agents, those that make a full-time career of it, who will have to straighten out the mistakes.

 

  Life insurance needs change as age and circumstances change. Therefore, what is right for a young family may not be right for a mature person with children in college. There are times when large amounts are needed and times when very little is needed. Some people do not need life insurance at all.

 

 

What is a Life Insurance Policy?

 

  Life insurance is a contract. The contract stipulates that, for a financial payment (the premium), a specified party, the insurer, will pay another party, the insured, or his beneficiary, a defined amount of money upon the occurrence of  death or some other specified event, such as disability.

 

  Life insurance insures a life against premature death or an untimely death.

 

  As long as a beneficiary, other than the estate, is listed the policy will bypass probate proceedings in most cases. Therefore, the face value of those policies on one's own life can be taken out of the estate tax by transferring the policies to the beneficiaries. Policies that are owned on someone else's life should probably not go to that person; in case the insured should die. If they do, the cash value will be taxed on the beneficiary's death, and the face value will be taxed on the death of the insured. One's will should probably direct that these policies go to the beneficiaries of the insured or to a trust for their benefit.

 

  It would probably be impossible to establish and manage an estate effectively without including life insurance in some form. Life insurance is an important estate planning tool used by nearly every estate planner. It can be used to provide cash for the payment of estate and inheritance taxes (where inheritance taxes apply), debts, administrative costs, and other estate expenses.

 

  There are, of course, varying types of life insurance. While most agents have personal preferences, nearly every type of life insurance works well in some specific situation.  In other words, each type of life insurance has its proper place. The experienced agent makes the best use of each type of life product rather than attempting to use only one type for every case. Which type of life insurance is best is not always agreed upon, even among insurance agents working for the same company. Since each type of insurance works well somewhere, it stands to reason that each type also does not work everywhere. Aside from what is illegal, the type of insurance used is often simply a matter of personal preference.

 

 

  When it comes to life insurance, the first step is always to figure out how much is needed. A single person with few debts and enough savings to cover funeral expenses will probably not need any life insurance at all. That fits few people, however. Eighty percent of Americans do own some form of life insurance.

 

  Anyone with dependents will need some amount of life insurance. Few people have saved enough cash to wipe out the need. Even families with relatively high amounts of investments usually need insurance for estate planning. There are many opinions on how much life insurance is necessary. Even though views may differ, a basic approach can be used. We have included the following worksheet:

 

Life Insurance Needs:

 

1.  Cash Requirements:

            A.  Estimated final expenses for burial:                                              $  __________

            B.  Probate, administration & executor fees:                                      $  __________

            C.  Education Fund (current and future):                                            $  __________

            D.  Debt payoffs; mortgage is optional payoff:                                  $  __________

 

    Total:                                                                                                           $  __________

 

2.  Annual Income Requirements:     

            A.  Yearly income requirements                                                         $  __________

(This is the amount required to maintain one's current standard of living which is 50 percent to 80 percent of present before tax income.)

            B.  Social Security benefits (survivor payments):                              $  __________

            C.  Spouse's or life partner's annual income:                                      $  __________

            D.  Other income (be sure this is certain before counting it):            $  __________

 

            E.  Net Income Required:                                                                   $  __________

                  (2A minus 2B, 2C and 2D)

 

            F.  Principal needed to provide necessary income:                             $  __________

(Inflation can be an uncertain factor.  Many professionals add 4 to 8 percent as a hedge against the potential erosion caused by inflation.)

 

3.  Assets:

            A.  Current Assets (cash, stocks, bonds, sellable real estate):                        $  __________

            B.  Current life insurance & annuity proceeds:                                  $  __________

            C.  Lump-sum death benefits from retirement plans:                         $  __________

 

    Total:                                                                                                           $  __________

 

4.  Insurance Amounts Needed:

            A.  Cash needs from (1):                                                                     $  __________

            B.  Principal needed to provide income from (2):                              $  __________

            C.  Minus available assets from (3):                                                   $  __________

 

    Total:                                                                                                           $  __________

 

 

 

  Using this table will help the agent discover whether or not the currently held policy is adequate for both current and future needs. If the policyholder's current policy has not been updated for some time, it may not give the quantity of insurance that will be needed.  In the table, it asks for the amount of money the family will need to live on each year. This is always a difficult figure to arrive at since opinions do differ. At least 75 percent of the current annual take-home pay should be used. Some families will desire a higher figure. Others may feel they would need less, especially if some items were cut out. Using too low a figure, however, is risky. No one would want their spouse or children to suffer as a result of trying to save a few bucks in premium dollars.

 

  Many families never consider future expenses until the insurance agent is sitting at their table asking questions. How do you plan to pay college expenses for your children? Have you prepaid funeral expenses? Do you know what your assets would be worth if they had to be sold? Does your non-working spouse have any means of support in his/her retirement? The questions are many and they will vary from family to family. The insurance agent is providing valuable services.

 

  As these questions are answered, the amount necessary will begin to sound like a lot of money.  While insurance will play a valuable role, all of the contingencies do not have to be provided with life insurance alone. For example, a burial plan could be purchased or prepaid. An IRA could be established for the non-working spouse. There may be assets that could offset the amount of life insurance needed.  Social Security might play a role in covering some of the costs.  Company pension plans might be found to provide more money than initially thought. If, however, it does fall solely on a life insurance policy now is the time to find out the need for it.  Not when a death actually occurs.

 

 

  Life insurance proceeds, except in unusual circumstances, are not taxed as income to the beneficiary. They also avoid estate taxes as long as the beneficiary is the spouse. This lack of taxation boosts the value of life insurance over other types of income.

 

 

Planning for the Future

 

  The creation of an estate, especially one that has been given much thought and preparation, requires the expertise of many people. Seldom is a single person equipped to properly manage the entire procedure. Since one of those professionals will surely be an insurance agent, it is important that the insurance agent understand how an estate must be set up. Even though part of the process will not directly involve insurance products, the agent needs to understand the entire process in order to perform his or her particular job completely and professionally.

         

  Life insurance products almost always directly relate to estate planning. Many consumers buy life insurance for the wrong reasons or for emotional comfort rather than actually analyzing actual needs. Life insurance is primarily purchased to protect a person or family from a major loss of income due to a death. Usually that loss of income would be in the form of the death of the major wage earner. However, that is not always the case. Often divorce settlements award a life insurance policy as a means of "future" protection.

 

  It is common to create an estate by investing in a life insurance policy, especially for young families. As the client's financial growth occurs, an experienced agent will recognize the needs that develop along with the growth of the financial picture. Often those needs are overlooked by the client themselves, so they appreciate an alert agent who spots potential risks or opportunities.

 

  Insurance is fairly basic: for a guaranteed loss (premiums paid out) an individual is protected against the possibility of a much larger financial loss (the peril insured against). Agents often refer to this as the "cookie jar effect."  Many individuals put a set number of cookies into the jar, but only those who experience a specific need are allowed to take any out. Each person involved knows that he or she will be donating or forfeiting some cookies, but they also know that they have the ability to take more out than they put in under set circumstances.

 

 

  There are two basic insurance terms no matter what type of policy one is considering. The guaranteed systematic loss is the premiums paid. Few people consider premiums in this light.  Most of us are more likely to consider them the cost of buying protection. Both are true statements. The potential financial loss, which insurance protects against, is the peril or risk that is insured against.

 

  Life insurance can be one of the most expensive parts, at least initially, in a good financial plan.  A well-structured life insurance plan that is used as a part of estate planning will eventually bring about the results desired by the consumer, however. This might be through the use of an IRA, annuities or even cash value policies. Not everyone needs a life insurance policy as a protection against premature death. If there is no one who needs financial protection from the death of the insured, then it makes little sense to carry a life insurance policy purely for this reason.

 

  It is unfortunate, but true, that many insurance agents are not given good training in the variety of products available. It is not unusual for insurance companies to push products on their agents that are not necessarily always best for the consumer. An alert agent, however, will investigate the products personally and use those that best fit the given situation. Certainly, consumers should buy life insurance products only when they need it and only for specific logical reasons. What those needs and reasons are will vary from family to family.

 

  The first step when considering insurance is determining the purpose of life insurance as it relates to the given situation. Understanding the reason life insurance is being considered will allow the agent to determine the type needed. The main purpose of life insurance is generally to replace lost family income should a wage-earner die or become disabled prematurely. Life insurance would be aimed at the death whereas disability insurance would address a potential disability. Therefore, life insurance should only be placed on those who earn income for other dependents. That would include a father who earns income to clothe and shelter his children and wife. A wife or mother who earns income for the family's support should also carry a life insurance policy, especially if she is the head of the household.

 

  Not everyone agrees with this specific guide for life insurance needs. That is because it cuts out the use of life insurance for:

1.      Single people with no dependents

2.      Non-working spouses

3.      Children

4.      Retired people who are currently living from the proceeds of past investments and income.

 

  While it is true that these four groups of people do not earn income, there are instances where life insurance might be appropriate for reasons other than protecting against financial loss from premature death. For example, a single person without dependents may wish to provide funds upon their death to cover outstanding bills, burial costs or even benefit a specific charity or university. However, it would be pointless to carry a large policy since these costs or gifts can usually be covered by a small policy of no more than $20,000 or $25,000. 

 

  Many authorities warn against insuring children, except perhaps for a burial plan of no more than $5,000. Since minor children are unlikely to produce income and even less likely to be supporting someone else financially, it really does not make sense to insure them with life insurance policies. Statistically, children do not die prematurely so even burial insurance may not make sense. For the grandparent who wants the enjoyment of giving something financial to the grandchildren, an annuity would be a better consideration.

 

  Except for those products used specifically for estate and tax planning, life insurance should always be considered as a protection against lost income. Those who earn more should carry more insurance; those who earn less should carry less insurance. Retired individuals should consider products other than life insurance products unless it is needed for estate and tax planning (such as payment of estate taxes). Single premium life products and annuities often work better for retired individuals than does an actual life insurance policy.

 

  When life insurance policies are purchased, beneficiary payout options are not given the amount of consideration that they deserve.  Generally, the proceeds are paid out in a lump sum to one or more beneficiaries.  Since life insurance is meant to replace lost income, receiving it all at once makes little sense in most cases. Few beneficiaries are experienced enough to manage it well. It is common for the beneficiaries to make serious mistakes which destroy the ability of the funds to actually help them over a period of ten, twenty, thirty or even forty years, as is needed.  Studies show that insurance money is generally gone in less than five years because of bad investments and other spending errors (new furniture, cars, etcetera). The money is gone but the children still need school clothes, health insurance and baby-sitting while the widow works.  The family could become financially destitute even though sufficient funds had been provided at the time of their father's death. This situation could have been avoided by simply setting up the insurance plan to have the proceeds invested so that income would have continued for an unlimited time or a set period of time, as desired. Many experts feel the life insurance trust is one of the best estate planning tools available.

 

  It is important to realize that estate planning is never the products used. Rather, estate planning is the use of procedures that will transfer assets at the time of death in an appropriate and desired manner. Because there must first be assets before any transfer can be made, life insurance is often the first step taken.

 

  There are many reasons why a person would desire and need a life insurance policy. Although it often has to do with estate planning, in many cases it is much simpler. Bob loves his wife and children. Should he die prematurely, he wants their financial needs taken care of. Therefore, he buys a life insurance policy. This purchase is as much an act of love as it is an act of estate planning. Although Bob purchased the policy from an emotional standpoint (he loves his family), his reasoning backs up the emotions involved (it makes sense to do so).

 

  When estate planning first begins, objectives are seldom the same as they are in later life.  Many factors change the direction of a person's life, and all of these changes may have an effect on the desires and objectives involved with the insurance policies purchased and the estate.  In the beginning, the consumer probably simply wants financial protection for his spouse and children. For a single individual, he or she may want to cover the costs of burial, so parents will not be burdened. Later, as people accumulate wealth or assets, estate planning will focus on retirement, enjoyment of life or providing for others, such as grandchildren. With additional wealth come redirected objectives. One of the most important factors which may change estate planning goals involves the people associated with one's life. Some potential beneficiaries may die or become distant (loose importance). New people, with new needs, may enter one's life. Such things as births, deaths, divorce, marriage, adoption and so forth bring about many redirected goals.

         

  Estate planning has many advantages, but certainly one important advantage is peace of mind.  Bob's purchase of a life insurance policy to protect his family gave him peace of mind. Having a goal is always a comfort and reaching that goal brings great satisfaction. As one goal is reached, another will take its place. Ultimately, the dedicated person will reach and surpass many goals in their lifetime.

         

  Much estate planning has little to do with the growth of assets but is geared instead towards providing for those people who are unable to provide for themselves. This would include the wife or husband who wants to provide for their children, but it also can include relatives who are physically, mentally, or emotionally impaired. It would be impossible to list all the wishes that financial planning may involve. They depend upon so many factors and emotions that the professional will simply enter into each new encounter with an open mind and a ready ear. It must be stressed that the art of listening is a most valuable asset to the career agent.  Communication skills are often more a matter of listening than they are of talking. The most successful professionals in all walks of life have perfected this listening skill.

 

  Typically, financial success is the product of goals which follow a set pre-planned path to some degree. Certainly, there will sometimes be deliberate changes in the financial plan and even occasional blunders, but a plan will still be followed to some degree. Financial planning is not accidental or theory. Financial planning involves logical ideas that work.

 

  Sometimes, the most difficult job an agent has is clarifying a client's objectives. In some cases, objectives may even be misdirected by the consumer. Obviously, this may be awkward, especially if the client is not facing reality. Graphs, such as pyramids, may allow an agent to bring forth realities without directly confronting the client in a negative manner. If an agent makes a client feel inadequate, he or she may fear making any decisions at all or even blame the agent for pointing out their errors in thinking.

 

 

  If a pyramid is used to show a client's assets, the same general format is generally used. Solid assets are placed at the bottom and less secure assets are placed at the top. When used for cash flow, a steady dependable income would be at the bottom, with such things as overtime compensation and other uncertain incomes placed towards the top of the pyramid.

 

  There was a time when insurance agents, as a whole, did not see the need to know any more than their own immediate products. As products have become more sensitive to the consumer, however, agents are finding that broader knowledge is beneficial. In some situations, broader knowledge is even essential.

 

  Planning a client's financial future can be extremely satisfying when you know you have done an excellent job.  Since financial planning is an ongoing affair, it cannot simply be set down and filed away. Do not confuse financial planning with the financial vehicles used. Financial planning is a procedure used; not the products sold.

 

 

Life Insurance Trusts

 

  Life insurance trusts are designed to distribute the funds provided by a life insurance policy.  Generally, the life insurance trust creates a continual stream of income for the wage-earner's dependents which ensures that there will be adequate money available on a month-in, month-out basis. The primary objective is usually to make certain that lost family income is immediately replaced (upon the wage-earner's death) and continues until no longer necessary. There can be other reasons, however, for using life insurance trusts besides creating continual income over a period of time. These other reasons might include:

1.      Controlling from the grave, so to speak, how insurance proceeds are invested.

2.      Preventing one or more of the beneficiaries from acquiring the insurance money in a lump sum which could be a threat to future income from a specific or involved investment.

3.      Enabling the life insurance proceeds to flow into the trust which removes the proceeds from the estate for estate tax and probate purposes.

 

 

  A trust is always a legal document. Life insurance trusts are no exception. Therefore, like other types of trusts, trustees must be chosen. Realize that simply naming specific trustees does not mean that they must accept the position. They may decline the job and it is not at all unusual for an individual to do so. Therefore, it is important that the position be discussed fully with them before the job actually materializes (the insured dies).

 

 

  The beneficiaries of the trust, like a will, are still the heirs even though a trust exists. The trustees of the insurance trust are responsible for the money contained in it. That does not mean that mistakes cannot be made. Therefore, once again, it is important to choose trustees wisely.  The money will be managed according to the instructions of the trust creator, assuming instructions were left. If the money is invested in an annuity, for example, the trustee or trustees (if more than one) will, if instructed, send the beneficiaries a monthly check for the amount desired by the trust creator. It is not unusual for the trust creator to leave the distribution up to the trustees. In such a case, it is especially a good idea to have multiple people involved as trustees.  When more than one person is designated, they are referred to as co-trustees. In such a case, any combination desired may be used, but most professionals would recommend that one person be a close and trusted friend or relative and another be a professional such as a banker or attorney. If an attorney is selected, he or she should not be the same attorney that drew up the trust.  This would most certainly create a conflict of interests. Gift tax rules normally do not apply to insurance trusts, since only the premium and not the value of the policy is counted for gift tax purposes. In addition, the payouts are generally not over the specified limit. Of course, the amounts and terms of distribution of the trust are up to the trust creator.

 

 

Types of Life Insurance

 

Term Insurance

  Term life insurance does not build cash reserves. Term life is often combined with other products, such as annuities or mutual fund accounts.

 

  Under term insurance:

1.      The insured must die before the term expires (the period of time during which the policy is effective).

2.      At the expiration of the term the insurance ends. A new term policy may be started, however, depending upon the terms of the policy contract.

3.      The cash outlay (premium) is relatively low, especially at younger ages.

 

  Even within the types of insurances, there can be sub-categories. Term insurance has basically four categories, although there can be variations of each category. The four types are:

1.      Annual renewable term insurance which is renewable each year regardless of the insured's health. The premium will be higher each year due to increased age.

2.      Convertible term, which allows the insured to exchange the policy without evidence of insurability. The exchange often means converting to a whole life policy or an endowment type of policy.  

3.      Decreasing term, which is often called Mortgage Insurance. The death benefit decreases over a specified period of time although the premium usually remains level.

4.      Level term insurance generally has both a level death benefit and premium cost for the entire term of the policy.

 

 

Whole Life Insurance

  Whole life insurance is often referred to as Permanent Insurance. Whole life or permanent insurance has several characteristics:

·         The premium remains level throughout the policy's lifetime.

·         The contract builds up cash reserves in the early years, which allows the company to maintain level premiums even though the insured becomes older, which would normally trigger higher premiums. These reserves also bring about a "cash value" which may be borrowed by the policyholder or may be taken as surrender proceeds if the policy is canceled.

·         A whole life contract, by definition, can be kept at the same premium level for the lifetime of the insured.

 

  There are both straight life and limited payment life whole life policies. Under a limited payment life policy, premiums are payable over a shorter period of time. Because premiums are paid over a shorter period of time, they are higher. In effect, one might say the cost is the same; the policy owner is just paying off the contract sooner.

 

  There are also modified whole life policies and preferred risk whole life policies. A modified life insurance policy typically provides a given amount of insurance at unusually low prices for an initial time period after issue and then the premium is higher for the remainder of the premium period. Modified plans usually have a lower initial cash value than a similar policy of another type might have.

 

  Preferred risk, as the name implies, usually requires that the insured be in better than average health at the time of application. Preferred risk policies are often sold to professionals or others in low risk occupations. Also, these policies are sometimes sold only in higher face amounts.  The premiums may be slightly less than standard policies.

 

Endowment Insurance Policies

  Endowment insurance is not used widely anymore. The primary characteristic of endowment insurance is that the contract pays the face amount at the sooner of either the time of "endowment," which is the maturity of the contract, or at the insured's death, if prior to the endowment date. Endowment life insurance policies are typically considered a type of "forced savings." In fact, the protection aspect of the policy is relatively low. Various types of endowment policies are often found in pension plans since the aim of pension plans is to provide cash during life. Since the cash values in endowment plans build up tax free, they are well utilized by individuals in higher income tax brackets.

 

Universal Life Insurance Policies

  Many consumers are aware of the term universal life but have only a vague idea of what it actually is. A universal life insurance policy is a life insurance policy in which the investment, expense and mortality elements are separately and specifically defined. The policyowner selects a specified death benefit which typically remains level.  The death benefit may, however, be one that increases over time, coinciding with the increased cash value of the policy (death benefit Option II), or, alternatively, the death benefit can remain level regardless of the underlying value changes (death benefit Option I). A load is deducted by the insurance company from the premium amount paid by the policyholder for defined insurer expenses. The premium remaining is then credited towards the contract owner's policy cash values. Mortality charges are next deducted. Interest earned on the remaining cash is credited at whatever percentage current rates happen to be. Since specific policy details do vary from company to company, variations will occur.  Increased expenses or loads and/or increased mortality rates will also result in lower cash values. Just like annuities, there is usually a minimum contractual guarantee on the interest rate earned; typically, around 4 or 4.5 percent. Mortality costs also generally have a guaranteed maximum premium charge for the pure cost of the death benefit. Most insurance companies do not charge that maximum rate, however. Typically, the rate actually charged is lower.

 

  Many consumers assume there is a "standard" universal life insurance policy that is somewhat uniform from company to company. Actually, there is no such thing as a "standard" universal life policy. The level of premium paid, the amount of the death benefit, and the length of time over which premiums are paid are all variable. While the first policy year may have a stated minimum premium due, following that first year, the contract owner may usually vary all factors: the premium amount, the payment date, and the frequency of the payments. These features are what make this type of policy favored by consumers.  These features are sometimes called Stop-And-Go features or options. The ability to discontinue payments and then resume them at a later date does not require reinstatement of the policy. As long as there are enough cash values within the policy to pay the required expenses and mortality rates, the policy will remain in force. The policy will terminate if the cash values are not adequate, although there is usually a grace period allowed of up to 60 days.

 

Variable Life Insurance Policies

  A variable life insurance policy is, in relation to other types of insurance, a relatively new product. The sale of a variable life insurance product usually must be accompanied by or preceded by a prospectus approved by the Securities and Exchange Commission.

 

 

  A variable life insurance policy resembles the traditional whole life policy but does have two major differences: both the death benefit payable upon death and the surrender value payable during life are not guaranteed. They can both increase and decrease depending upon the investment performance of the assets upon which the policy relies. The death benefit generally cannot decrease below the initial face amount, however, assuming all the premiums have been paid. With this type of policy, the consumer trades the cash surrender value guarantee for the potential of investment growth.

 

  The policy owner may direct the premium (after certain deductions are made) to a specific sub-account held by the insurer. What those sub-accounts are will vary and may include a money market account, a growth stock account, a bond account, or some other type of investment vehicle. Some companies may allow changes among the accounts more than once per year while other companies may have limitations on the number of times that funds may be moved among the various investments. Usually, the death benefit is adjusted once per year while the cash value is adjusted on a daily basis. Premiums tend to be fixed so that they remain the same. The product gets its name, variable life, because both the surrender value and the death benefit can vary.

 

  Before any of the contract's funds may be diverted into a sub-account by the policyowner, charges must first be paid. These charges would include administrative and sales expenses, any state premium taxes, and of course, mortality costs.

 

  For those policyholders who desire to take an active role in their finances, a variable life policy is an attractive mode of life insurance. The policyholder has the ability to direct where their premium dollars are placed.

 

 

  Variable life insurance policies enjoy the same income tax treatment as other types of insurance policies. Earnings from the investments are currently income tax-deferred, which, of course, is always a benefit to the consumer. There is no tax on the internal build-up of cash values. If the policy is surrendered (cashed in), and if the cash proceeds are more than the policyowner's cost basis, then the proceeds may experience some taxation. Death benefits, regardless of growth, pass income tax free in most cases.

 

  Most variable life policies allow the policyowner to borrow a designated percentage of the cash value without surrendering the policy. Normally, the insurance company will charge interest on the loan, but often the rate is lower than the rate that would be charged from a bank or lending institution.

 

  Like other insurance policies, one may see riders and/or waivers added to the basic policy. These might include such things as accidental death riders or waiver of premiums if disability occurs.

 

Survivorship Life Insurance

  Survivorship life insurance is also called Joint-And-Survivor Life insurance. Survivorship life insurance is used to insure two or more people under the same policy. There are variations offered for this type of policy including some universal life products.

 

   The death benefit is not paid under a survivorship policy until the last of the two or more insured individuals die. At that time, the full death benefit goes to the named beneficiaries. Since there are so many variations to a survivorship policy, the agent involved must pay special attention to the provisions listed.

         

  Most of the survivorship life policies use whole life products, although other types are also available. They provide for an increase in cash values upon the first death of one of the insured individuals. If the policy is a participating policy which pays dividends, the dividends would then also increase. Depending upon the terms of the contract or policy, the premiums may continue until the survivor's subsequent death. It is possible that, through a special option, the policy is paid up at the first death so that no further premiums would be required.

 

  As with other types of policies, there must be an insurable interest on the individuals insured in the survivorship life policy. This type of policy is typically used between spouses, parents and children, or related business owners. This type of policy is effective in easing federal estate taxes on those who would be subject to such taxes and have elected to take maximum advantage of the marital deduction, which would have tax due upon the survivor's death.

 

  It should be noted that there is no requirement that all those insured must also be policy owners. The policy may be owned by any party that could own any other type of insurance policy.

 

Single Premium Whole Life Policies

  Unlike traditional life insurance policies, the Single Premium Whole Life policy has only one premium payment (thus the name single premium). The initial premium is paid up front with no further premiums required.

 

  Single Premium life offers many of the traditional tax advantages offered by whole life policies:

1.      The money contributed to the policy builds up tax free through policy cash values.

2.      The policy owner can borrow those cash values tax free.

3.      The proceeds from the policy (the face value which is different than the cash surrender value) at the death of the insured would go to the beneficiaries income tax free and without going through the procedures of probate.

 

  The immediate cash value of the policy is, of course, one of the main reasons for which a consumer would select a Single Premium Whole Life policy. The cash value may be accessed through policy loans or by surrendering the policy. Since the insurance company imposes penalties for early surrender, loans make the most sense in the early years of the policy.  Although the insurer will charge interest on any loans taken out, in many cases, the insurer will also credit the policy with an interest earning on those borrowed funds. As a result, the policyholder may pay only a percentage point or two. If the two percentage rates paid are identical, they will cross each other out entirely which gives a zero-net loan cost.

 

  For example, Connie Client has purchased such a policy. She borrows $10,000 from it. The insurance company charges her six percent of the amount she has borrowed. However, the insurance company also credits her with six percent of the borrowed funds. Therefore, she has an actual loan rate of zero.

 

What are Tax Deferred Annuities?

 

  Deferred annuities have been used for years, but they have become more and more popular as tax reforms have occurred, and other investments have experienced high losses.

 

  Deferred annuities can, if desired, serve as an alternative to the IRA. Some individuals lost some of their incentives to continue making IRA contributions following tax reform. Although annuity contributions are not tax deductible (unless used to fund a qualified account), earnings do accumulate tax deferred. One advantage of an annuity over an IRA is the fact that there is no limit to the amount of money that may be invested in an annuity. An IRA is limited to a specified amount yearly for a working individual.

 

  Deferred annuities may be considered to be part insurance and part investment, although there is no actual life insurance involved. The accumulated funds would be the investment portion and the available guaranteed regular monthly income payments for life (if annuitized) would be the insurance component. There are several annuity payout options available. Guaranteed lifetime income is only one option available.

 

  The popularity of annuities seems to go up and down depending upon current trends. During times of inflation and high interest rates, tax-deferral is more important to consumers. As a result, when interest rates are high, annuities should be one logical investment choice. Many people use annuities as a pension for varied reasons. IRAs and Simplified Employee Pension Plans (SEPP) work well when placed in annuities.

 

  While annuities may seem confusing to many consumers, they actually have many of the same properties as a bank loan. A bank deals in credit, as most consumers realize. A bank lends money because it expects to be paid back, with interest, over a set period of time. When a consumer deposits money into an insurance company's annuity, he or she expects to receive back all of their principal, plus interest. In a manner of speaking, the consumer takes on the role of the bank. They allow the insurance company to invest their money and in return the consumer is paid back the principal, plus interest. The insurance company issuing the annuity invests in long-term investments which earn a higher yield than the rate of interest they are paying the depositor.  Since the company invests in long-term investments, penalties are imposed if the depositor withdraws their money prior to the term of the annuity contract. The actual length of the contract term will vary from annuity to annuity.

 

  Annuities have many variations, but they do all fit into one of several basic forms. Annuities may be paid in (or loaned to the insurance company) by a:

1.      Lump sum deposit, called a Single Premium Annuity,                                    

2.      Series of fixed installments, called a fixed premium annuity, or               

3.      Series of installments of whatever size is desired, called a variable premium annuity.

 

  Of course, the investor will receive a return on their investment in the annuity. How that return is received may also vary. An annuity may be used as the vehicle for an IRA (Individual Retirement Account) or a Keogh Plan with all the advantages of an IRA or Keogh plan.  Otherwise, only an annuity's interest earnings are tax deferred. The principal would not be unless, as stated, the annuity is used to fund such things as IRAs and Keogh plans. Traditionally, an annuity is a tax-deferred investment.

 

  For many Americans, the term "annuity" is a hazy concept. While they may have heard the word and may even know that it has to do with an insurance company, relatively few understand any of the features involved. Many people are not sure whether to classify an annuity as an insurance policy or an investment.

 

  The word annuity means "a payment of money." The insurance industry designed them to do just that. Although the deferred annuity was originally designed with income features in mind, today they are looked at more for their ability to accumulate and less so for their ability to distribute income at a later date. Since it is important for the consumer to have confidence in the safety of the company used, it is important to recommend investment grade annuities to potential clients.

 

 

  As with all insurance products, due diligence is essential when recommending a product to a client. This is certainly true of annuities also. There can be differences in annuity products that may be critical to the needs of the client; especially when establishing and maintaining an estate.

 

  An annuity is often used as a safeguard against living too long; outliving one's income or savings. Although annuities are not life insurance policies, they certainly have a place alongside them. Perhaps the main difference between the two is that life insurance policies are used primarily to guard against financial disaster at death and annuities are used to guard against financial disaster during life. Annuities have a minimum interest rate stated in most policies.  When interest rates dive, as we saw in late 1992, this minimum rate becomes advantageous. The minimum rate is the lowest rate of interest that would be paid to the annuitant no matter what else happens. Of course, the annuitant prefers a higher rate than the minimum stated in the contract, but that may not always be realistic.

 

  Most annuities have a 100 percent guarantee of principal and an ongoing guarantee of all accumulations. Since contracts do vary, however, it cannot be stressed enough that the writing agent must read the contracts in their entirety before recommending a product or stating how it operates.

 

  Annuities are used for many purposes besides retirement, although that is a common use. They are used for business partner buy-outs, education needs (such as college) and deferred compensation plans.

 

  The history of a company's investment portfolio should be considered before recommending a company to a client. So, should the quality of bonds and investments in the portfolio. As an agent, you will also want to be aware of the length and amount of surrender penalties involved. It is not unusual for those penalties to have a direct relationship to the commissions paid. To be ethical, commissions paid should be at the end of the list when considering products for your clients.

 

  Chargebacks of commissions may vary greatly from company to company. Many companies will charge back the earned commissions if the annuity is surrendered by the policyholder in the first year. Some will charge their agents a charge-back if the client dies within a set period of time as well. Some companies charge back commissions if the client annuitizes their contract within the first five years. Some insurance companies impose chargebacks by graduation into the second and third years. This is something that the agent will certainly want to investigate and be aware of, although it should not be the sole criteria used to judge the products.

 

 

The Annuity

 

  Annuities are an extremely useful estate planning tool. Annuities are a form of capital that the individual cannot outlive, if annuitized for a lifetime income. Since annuities give the ability to have a monthly income, it allows other wealth to be distributed, if so desired, for the pleasure of giving or to reduce taxable assets. In some of the larger estates, the freedom to dispose of taxable assets (while enjoying the pleasure of giving such gifts) can virtually eliminate taxation. Annuities can also cut down the expense and delay of probate if the contract names beneficiaries other than the estate.

 

  The annuity has seen times of popularity and other times where it is not so popular depending on how the interest rates are faring. Retirement trends are focusing on annuities in growing numbers as workers become more and more fearful of inadequate pension funds. Annuities are also being marketed more and more by individuals in banks and other firms.

 

  An annuity is simply a periodic fixed payment for life or for a specified period, made to an individual by an insurance company. In the last few years everyone from bankers, stockbrokers, accountants and even attorneys have acquired insurance licenses. Probably the most notable industry to go into the insurance business is the banks and savings and loan institutions.

 

 

  Many insurers are jumping through hoops to provide contracts and assistance to enable the banks to sell their products. There has been some very successful marketing done through the banking and savings-and-loan institutions. Some have noted, however, that many of the sales of insurance products have also experienced a loss of earning potential (for the client) due to expenditures and costs attributed to banking activity. These expenditures can sometimes be attributed to the banking industry's "invisible profit." Over all, the sale of insurance products, primarily annuities, has been a success.

 

  As we have noted, annuities are often considered an investment that protects an investor from living too long. It is interesting to note that the experience of insurance companies show that those who purchase annuities do, in fact, tend to live longer than the general population.  While we do not know why that is, it could probably be safely assumed that it has something to do with less stress about financial matters. Perhaps there is less concern by the annuitant that, in their old age, they will do something foolish with a bulk sum of money since, once annuitized, there will simply be a monthly income set for life.

 

  Annuities have long been noted for their stability. Finding a safe investment and a decent interest rate is a common investment objective. To the general consumer, an annuity may not look much different than a Certificate of Deposit. Therefore, many people may prefer the certificate since it is at their local bank. The fact that they can go stand in the middle of their bank (and cannot go stand in the middle of the insurance company) may cause them to continue in their Certificates of Deposit. However, upon closer evaluation, an annuity is a much better buy. While the interest rates may appear similar, when taxation is factored in, the annuity offers much more return assuming that the money is being left to multiply.

 

  In the early 1920s, the United States government began using annuities to fund government retirement plans, as did labor unions. Due to the requirements the government mandated; the insurance industry came up with two safety features:

1.      A guaranteed minimum interest rate is built into the annuity contract.

2.      The reinsurance network.

 

  Backed by the insurance companies' reserves, a reserve system for annuities was first introduced during the 1920s. The legal reserves system required then, and still requires today, that insurance companies keep enough surpluses on hand to cover all cash values and annuity values that may come due at any given time. It is these reserves which enable the minimum interest rate guarantees to exist.

 

 

The Reinsurance Network

 

  The reinsurance network was designed so that if there was a large run on the money in the insurance industry, no one particular company would be required to take the brunt of the loss. The insurance companies spread the risk out among all of the companies offering similar products.

 

  When the great depression hit the country in the late 1920s, over 9,000 banks went under (bankrupt). Certainly, the stock market was devastated. Stocks and bonds simply were not worth anything. There was no money and no way to obtain any money. The exception to the utter economic disaster the country experienced was the insurance companies. They had enough cash on hand to pay their policyholders. The companies continued to pay their guaranteed minimum interest rates that had been established years earlier. After the depression hit, new laws passed by Congress required many of the other financial industries to provide some of the same safety features on their products.

 

  Certainly, a lot has happened since the 1920s and today we are hearing dire predictions from some for the life insurance companies. History has shown, however, that policyholders do not lose money with life insurance products. Even during serious failures investors do not lose their money, although delays in receiving their funds can certainly happen.

 

  Annuities have an interesting history which few agents happen to look at. From 1973 to 1978 the most popular annuity products carried a permanent seven percent surrender charge.  Yes, that is right: a permanent surrender charge. The only way to avoid this charge was to annuitize.

 

  Then a few innovative companies began to add other features, such as bailout options and limited surrender penalties. Bailouts allowed clients to withdraw their money without penalty charges if the interest rate on their annuity fell below the initial rate. Once the bailout feature hit the market, a new generation of products developed.

 

  In the 1980s, the New York Stock Exchange member firms began to aggressively market bailout annuities. As interest rates hit all-time highs, insurance companies quickly had to become superb asset managers as well as good risk managers.

 

  It was at this time, when record high interest rates fueled uncontrolled growth, that the insurance industry experienced significant setbacks. One such setback was Baldwin United.  Their internal investments and questionable accounting procedures eventually resulted in their block of annuity business being sold to Metropolitan Life.

 

  Charter Oil suffered from the 1981-82 over-supply of oil and gas that crippled the entire industry and resulted in Charter Oil selling their annuity block to Metropolitan Life also. There is one very important point to make note of: in both cases, the contract holders did not lose any of their investment. Policyholders continued to earn tax-deferred interest in the seven to eight percent range. The system worked - without a government bailout. This is a point that is probably missed by the general consumer.

 

Index Rate Annuity

  The early 1980s saw the introduction of indices (index rates) and two-tiered rates. The index rate annuity is a fixed annuity whose renewal rate fluctuates during the surrender charge period based upon some independent market indicators. It might be based upon Treasury-Bills or any variety of bond indices. This type of indexing is designed to protect the consumer in a low interest rate environment. These products do not tend to have bailout options since they are designed to accurately reflect the changing financial climate as it occurs.

 

Two-tiered Annuities

  The two-tiered annuities are designed to reward the consumer by offering a higher first tier interest rate when they do not surrender their annuity. If the policy is surrendered or transferred to another carrier, a lower interest rate (which is the second tier) is retroactively applied. The two-tiered has, in effect, a second and permanent surrender charge in the form of the lower interest rate. The two-tiered annuity never did gain the popularity that the other annuities still enjoy.

 

  The two problem companies previously mentioned, Baldwin and Charter Oil, and the passage of TEFRA, caused annuity sales to drop. During this time, new annuity products emerged.  Surrender periods were reduced, bailout provisions improved and a move towards multiple year guarantees developed. It was not unusual for three and five year guarantees to be offered by the major companies. Many of these new annuities were specifically designed to compete with Certificates of Deposit. It was also during this time that banks and savings and loan institutions began to market their own annuities.

 

  During the 1990s, annuities began playing a larger role. Although there certainly are products which will take the consumer on either a long ride (due to longer surrender periods) or an expensive exit (due to high penalties), many of the products now offered are very consumer oriented. If interest rates continue to stay low, the sale and promotion of indexed rate products will likely grow. This will be a reflection of the consumer's fear of rising future interest rates and their desire to have upside protection. In other words, if the interest rates rise, the consumers want to be sure that his or her annuity yields will also rise.

 

  As annuities become more competitive, insurance companies may be tempted to over-extend themselves. Due Diligence requires that the agent evaluate the insurance carriers that they represent. An agent should know where their carriers are investing their money. An agent should know for how long the money is invested. Most importantly, an agent should know the ratio of assets to liabilities in the companies they represent. Remember that the size of the assets alone means very little. If liabilities outmatch assets, trouble could possibly develop.

 

  One of the major reasons that our savings and loan institutions came into such trouble was due to the competition which drove the interest rates up that were offered on Certificates of Deposit.  The rates simply went higher than the institutions could afford. Certainly, other factors were also a part of the problem, but interest rates that were too high was a major problem.  Now every savings and loan institution are regulated by the United States government. If we wish the insurance industry to remain outside of further government regulation, it is important to understand that bad products cannot exist if agents and brokers do not sell them.

 

  Annuity sales (investments) have nearly tripled over the last ten years.[1] Tax deferred earnings, guaranteed interest rates, safety of principal, liquidity, and freedom from probate are good reasons for looking towards annuities in record numbers. In addition, most annuities do not have any sales charges deducted.

 

  While there are many reasons to purchase an annuity, the most stated reason is the tax deferral advantage. Tax deferral makes a difference in several ways:

1.      The interest earned on the principal is not taxed until withdrawn.

2.      The interest earned on the interest compounds without taxation.

3.      The amount which would otherwise have been paid in taxes is allowed to compound, so it therefore continues to work for the annuitant.

 

  Taxes will eventually have to be paid. However, since the annuitant is in the position of deciding when to withdraw funds, the annuitant also decides when the taxes will be paid. This can be most beneficial.

 

  A part of each payment received by an individual from his or her annuity is considered to be a return on his or her original investment and is, therefore, excluded from their gross income. The amount of this exclusion from the gross income is determined by the ratio of the investment to the total expected return under the contract. The return is the amount of each annual payment times his or her life expectancy. This exclusion ratio remains fixed, despite the fact that the annuitant may die before or after their normal life expectancy.

 

  When an annuity contract provides for two or more people, such as a survivorship annuity option, an exclusion ratio is determined for the contract as a whole by dividing the investment in the contract by the aggregate of the expected returns under all the annuity elements.

 

  The average annuity buyer is over 60 years old (past the IRS penalty age of 59 ½). All the talk about the graying of America is true. Senior Americans control over fifty percent of all discretionary income. There are millions of people in our country over the age of 50, many of which are over the age of 65.

 

  In 2011, the first of the baby boom generation reached age 65. For the next 18 years, boomers began turning 65 at a rate of about 8,000 per day. As baby boomers grow older, it is changing many aspects of American life. Although many in this group saved inadequately and continue working out of need, there are also a percentage of them that saved very well and will look at investments with an interest in longevity and continued income.

·         The typical annuity owner is predominately middle-class, with an annual household income of $40,000-$75,000.

·         58 percent of annuity owners are retired, and 35 percent are employed either full or part time.

·         The average annuity first-purchase age is 50.

·         The average annuity owner age is 66.

·         46 percent of annuity owners are college graduates.

·         56 percent of annuity owners are female, while 44 percent are male.

·         Females are slightly more likely to own a fixed, as opposed to variable annuity.

 

Why Owners Bought An Annuity

·         78 percent of annuity owners report buying the annuity as a source of retirement income.

·         83 percent of annuity owners report buying the annuity to ensure lifetime income.

·         88 percent of annuity owners cite the tax advantages of annuities. 

·         49 percent of annuity owners are concerned that serious illness or nursing home care will bankrupt them in retirement and hope a deferred annuity covers them against this risk.

·         59 percent of annuity owners express little concern about having to cut back their standard of living during retirement.

 

Annuity Contract Statistics

·         43 percent of annuities are valued under $100,000.

·         51 percent of owners hold a fixed annuity while 49 percent hold a variable annuity.

·         Younger investors (under the age of 64) are more likely to own a variable annuity.

 

Top Sources of Funds for Purchasing Annuities

·         Savings or current income (over 50 percent)

·         Proceeds from another investment

·         An inheritance

·         Sale of home of business

·         Death benefit from life insurance policy

·         Gift from a relative

·         Employment bonus

 

  Although annuity popularity goes up and down, since the money in the annuity accumulates on a tax deferral basis, inflation is better controlled. Inflation is with us no matter what investment tool is selected. If, however, taxes can be put off to a later date, inflation is lessened.

 

 As always, when it comes to compounded growth, the more time available, the better the results will be. Probably the largest problem Americans have is not saving soon enough. Procrastination costs American citizens thousands of dollars in lost interest gains. Only a few dollars saved early in life would have resulted in greater returns than does more dollars saved later in life. The old saying "time is money" certainly applies when it comes to compounding interest.

 

  The average annuity buyer, according to numerous surveys, is looking for security, not a gamble.  Annuities are certainly safety oriented products as a whole. The following are some points that an agent may wish to consider before signing up for an annuity product.

1.      As with any insurance company for any product, make sure that the company is financially strong. Few clients appreciate having to wait to retrieve their own money because a company becomes financially unstable and goes into state receivership. 

2.      Check out any charges that may apply. Most annuities do not have administrative charges, but a few do. If you are dealing with a company that has such charges, you may wish to do some comparison shopping.

3.      The majority of annuities have surrender charges. These are, after all, long-term investments. However, some companies have much longer surrender periods than others.  It is also wise to check the severity of the surrender charges in the contracts. How many years at what percentage?

4.      Heavy surrender penalty products do tend to pay the highest commissions. A company that plans to credit the policyholder with competitive renewals should not need to impose excessive penalty charges. A competitive annuity will usually set the first year’s surrender penalty percentage within a point of the length of the surrender penalties in terms of years.  For example, a company would list a 9 percent penalty in the first year of a 9- or 10-year surrender period. Normally, the percentage of penalty declines one point per year. However, if the initial interest rate runs congruous with the initial rate guarantee, then the penalty structure may not decline. Clients generally prefer the lowest surrender periods over longer ones, especially those who are accustomed to Certificates of Deposit.

5.      Withdrawal provisions are often thought to be guaranteed in an annuity. While many are, some are not. Typically, a yearly 10 percent free withdrawal is allowed from the second policy year on. Some may allow a withdrawal in the first year; others may have no free withdrawal provisions at all. While most policies give a guarantee of withdrawals, as stated in the policy, some products consider it simply a "current company practice" which is subject to change or retraction at any time. Withdrawals defeat the point of deferral, but they are still a very important feature to the client.

6.      After safety, the interest rate paid is usually a primary concern to your clients.  If you have selected a company because of multiple factors, be sure to discuss all of your reasons with your client. Otherwise, a competitor will sway your client with a higher paying interest return or other options that you did not discuss at the point of sale.  Initial interest rates may carry little or no guarantees. It is not uncommon for a company to offer an initial interest rate for only three months or so. Generally, it is recommended that there be some type of written statement as to how the interest rates paid are derived at.  If no statement is included in the contract, the annuitant is at the mercy of the board of directors who can legally drop the rate of interest paid down to the stated guaranteed rate.  While that is not likely to happen, that option is available. An ideal feature in an annuity contract is a bailout option, which allows for the full surrender of the contract, free of company imposed penalties, if the interest rate ever falls below a predetermined level.  The bailout option should be competitive in and of itself. The spread between the initial rate and the bailout rate should not be greater than one or two percent, if possible.

**CAUTION** Check over the bailout option carefully. Some bailout provisions are nearly worthless. Some have adjustable bailouts which start out high but can be lowered at the end of the first year.  If the bailout can be lowered, it is a nearly sure bet that it will be. The bailout is designed in this case to protect the company rather than the consumer.  

7.      Some products have what is called a "use it or lose it" bailout feature. This means that if the bailout option is not utilized within 30 to 90 days of the first available opportunity, then the bailout option is lost. Most bailout options work best with a 1035 exchange. 

8.      The history of a company is one of the best indicators there is when it comes to performance. Of course, any company can change its philosophy regarding the treatment of its policyholders for better or worse. Most people are more likely to want written guarantees rather than expectations based on past history. The CD-type annuity, in which the initial interest rate is guaranteed for the length of the surrender penalties, has become a very popular SPDA (Single Premium Deferred Annuity).

9.      Annuities often carry special provisions or features. These can range from special surrender options triggered by specific medical problems to frequent withdrawal features.

 

  Simply put, an agent who sells annuities is foolish if he or she has not read the entire annuity contract personally. Furthermore, if any part of the contract was not completely understood, then questions need to be asked of the insurance company. Make sure the answers received are clearly understood and acceptable to you as the agent.

 

  Many agents say that, while they do occasionally sell an annuity contract, they do not feel as comfortable with them as they would like to. Every article warns agents that they must be careful to check out every product and understand every feature before managing the sale of the product.   We realize that this would surely be a full-time job in itself. Therefore, it is often a wise idea to contract with a brokerage or agency that specializes in annuities. Chances are that their personnel can steer you to the best products for your clients. As with insurance companies, you will want to be sure you are comfortable with the brokerage or agency that is selected.

 

  Often annuity contracts are merely a repositioning of client assets from one investment to another. It is, so to speak, a transfer from one investment vehicle to another. There are many reasons why people buy annuities. Often it involves pension and exchange sales, which is a repositioning of retirement money. CD rollovers represent some of the most common annuity sales that involve a repositioning of assets. Since annuities offer tax incentives that CDs cannot, this is not surprising. There are multiple charts that emphasize the difference in compounding tax-deferred over taxable investments. 

 

  Thousands of dollars have been spent in an attempt to define the buying motivations of our older citizens. It is generally felt that they are conservative, risk adverse, often skeptical of new avenues of investment, and they will nearly always select quality over price. With annuities, we would consider the price to equate to the interest rate paid.

 

  Annuities will continue to play an important part in the investor's overall financial picture.  However, interest rates paid must take a back seat to the security and financial stability of the insurance company used. Agents must begin to be as seriously concerned about safety as is the client.

 

  There was a time when many agents were careful not to mention the words "life insurance" when presenting an annuity product to a consumer. As a result, many people have thought that an annuity was essentially a Certificate of Deposit. The major differences were not always discussed or disclosed by the agent. That was unfortunate since those major differences were what made the annuity a sound investment.

 

  It is not a difficult thing to present annuities correctly. Doing so will not cause a loss of sales. As was stated previously, safety is the main concern of the majority of annuity buyers.  Therefore, the safety of the product should be correctly addressed.

 

  The Legal Reserve System consists of two lines of defense which includes the portfolio that backs an annuity and the net worth (which is capital and surplus) of the issuing system. It only makes sense to completely explain where the money is invested, how the insurance company makes money (so that it will survive as a company in today's market), and the capital safeguards available as an offset to any market volatility. Giving the client all of this information up front not only sets a foundation of security for the investor, but also makes sense from a sales standpoint. Our industry (insurance) is a valuable and needed occupation. The amazing record of solvency, which many older Americans remember from the days of the depression, is explainable and should be explained.

 

  Although an annuity is, in a true sense, the OPPOSITE of life insurance, it is still an insurance product. Agents have every reason to be proud of that fact since it carries with it many additional benefits that other products lack. A Certificate of Deposit (CD) cannot boast such features and that is where much of your annuity business is currently residing.

 

 

Per Stirpes

 

  Annuities have definite estate advantages. If properly set up, an annuity will eliminate some delays and costs of probate. The annuity gives the owner of the contract control of his annuity assets through restrictive beneficiary designations. For example, by adding the words "per stirpes" (which is Latin for "through the blood") to the beneficiary listing, the owner's annuity assets will NEVER be distributed outside of his own bloodline even if the beneficiary listed has died before the owner. "Per Stirpes" is sometimes referred to as an "in-law-avoidance clause" for this reason.

 

  It is also possible to restrict the ways in which a beneficiary may receive the annuity funds. It may be set up in a variety of ways, as the contract owner sees fit. Also, an often overlooked feature of an annuity is the privacy it affords. Just as a living trust is private, so too is an annuity. Only the insurance company and the beneficiary knows what the conditions of the contract are.

 

 

  There are numerous living advantages that are often overlooked by the agent as well as the annuitant. Social Security benefits may actually be increased when funds are transferred to an annuity since annuity accruals are not minifying factors the way alternative investments often are. Many states also consider the annuity to represent what is called beneficiary-designated money. Under such a definition, this investment may be much more difficult to attach in some states, should any future litigation occur.

 

  Many older Americans have a fear of living too long, which means outliving their assets. There are settlement options which offer the senior citizen the right to convert their core savings at any time into tax favored, monthly income that can last for either a specified time period or for the annuitant's lifetime. Although many, many annuities are never annuitized, the fact that this feature exists should not be overlooked.

 

  Having stated all of the features that make an annuity so important to an investor it is easy to see why the interest rate paid should not be the primary feature promoted by the agent. Safety, security, and the emotional considerations all are above the rate of interest paid.

 

  Mutual fund investors have begun to move a record number of their assets over to annuities.  While mutual funds have been, and still are, a major investment area, many people have experienced a loss or a lowered interest earning. Often these people are ready for a change to something stable and growth oriented. Mutual funds do vary, but generally speaking, over a five-year period, annuities tend to have equal growth in comparison to mutual funds.  An investor would generally see little difference in growth between the two. Some experts feel that certain annuities have actually done slightly better than mutual funds over the last ten years. Although there are some investments that may out-perform annuities for short time periods, for long-term safety and return of an investment, annuities continue to be one of the best places a person can invest.

 

  Many annuity professionals have expressed concerns that too many agents do not understand the advantages of marketing variable annuities over mutual funds. Many agents sell what they prefer to sell; not what the client would prefer to buy. The advantages of variable annuities over mutual funds have to do with taxation. When people reinvest their income, taxes can take a bigger bite. For a person who is saving for retirement, taxes can easily take a bigger bite than inflation in some situations.  Therefore, it is important to minimize taxation.

 

  Every so often, one hears the argument that, since taxes are going up, it is better to pay the taxes up front. That is a sales ploy! Even though taxes do tend to rise, the bracket of taxation that one finds oneself in at retirement is more likely to be lower than the bracket they found themselves in during their working years. In illustration after illustration, regardless of the company, tax-deferral is always shown to be beneficial.

 

  Lipper Analytical Services of Denver, which monitors mutual fund and variable annuity performance, states that a review of fixed income mutual funds and equity mutual funds show that they have under-performed when compared to similar groups in variable annuities. In fact, almost every major mutual fund complex is now in the variable annuity business.

 

  To recap:

1.      Annuities give a competitive yield;

2.      They are tax-deferred;

3.      They offer security;

4.      There are typically not any administrative costs;

5.      Liquidity varies with the annuity selected, but generally at least 10 percent per year is available; and

6.      Annuities avoid probate proceedings if properly set up (lists a beneficiary).

 

  Having recapped the annuity features, another point needs to be observed: features are not usually the actual reason that a person buys an annuity. Although this may initially sound odd, it really does make sense. Let us illustrate this point by looking at why a person might choose a doctor. Often people choose their doctor based merely on his office location or whether he or she accepts Medicare assignment. Whatever the reason for choosing the doctor, the reason the doctor is seen has nothing to do with the factors used to actually select the doctor. The doctor is seen because an illness or injury exists. Choosing the doctor was secondary to the need to see a doctor. So, it often is with the annuity buyer. SELECTING the annuity is secondary to the reason the annuity is NEEDED. The need may be the tax shelter offered, a need for estate planning in general, or any number of other reasons. The point is, there was a need first and a decision to purchase an annuity second. It is the actual need that should be addressed by the agent before the specific annuity is recommended.

 

  Most annuities are purchased individually from insurance companies. Insurance companies are required by law to maintain certain reserves, so an individual purchasing an annuity is virtually certain of receiving the stipulated amount in the contract. All the insurance company's activities are under the supervision of state regulatory agencies. A very different situation exists in the case of annuity arrangements with private parties, called a private annuity.

 

  If a person transfers property to a private party (such as a relative) in return for the promise of payment of a stipulated annual payment for life, the annuitant may be parting with property worth more than the value of the annuity. In that case, he or she has made a taxable gift.

 

  The Internal Revenue Service has published tables for valuing private annuities since there is certainly not the same assurance that the private annuities will be paid. A loss under a private annuity is disallowed for federal income tax purposes where the other party is a spouse, brother, sister, ancestor, or lineal descendant. Various fiduciary relationships between the parties also can result in automatic disallowance of any loss.

 

  Many people utilize annuities for retirement. There are three basic types of annuity contracts:

1.      The Immediate Annuity where one puts in a lump sum of money and then immediately begins withdrawing payments from it. There are variations from company to company in how this may be collected. Some annuitants may choose to collect only the interest earned, while others may actually annuitize it and collect both interest and principal.

2.      The Deferred Annuity where one large deposit is made, but payments are postponed to some future date.                                                         

3.      The Accumulation Annuity where one pays into the account on a systematic basis over a period of years. At some later date, it will provide retirement income. The shift from accumulation to monthly payout is called annuitizing. Before the contract is annuitized, the owner of the contract (which may sometimes be different than the annuitant) may withdraw any part of what is in the account. It would be subject to any company penalties in the early years of the contract. After the contract is annuitized, the monthly payouts based on the terms of the contract become frozen. The contract owner cannot withdraw anything more, just the monthly payments. Annuities may have tax penalties if withdrawn prior to age 59½ in addition to any company penalties if it is an early withdrawal.

 

  Annuities provide a life-time income and do combine the two desirable features of investing:  (a) deferred taxes and (b) growth without undue risk. An annuity is a contract between a life insurance company and the contract owner.

 

  It is becoming increasingly popular to list the annuitant as one person and the owner another person. There are several reasons why this might be done. It may be a way of giving the annuity to another upon the owner's death; it may be due to the limiting age of the policyowner; it may even be used to maximize the commission an agent may earn. Even though a life insurance company is involved, an annuity is not life insurance. An annuity is the opposite of life insurance. Life insurance is designed to provide money at death; an annuity is designed to provide money until death.

 

 

 

Single Pay Deferred Fixed Annuity

  The oldest type of annuity is the Single Pay Deferred Fixed Annuity. The owner pays the insurance company a certain amount of money. Generally, companies require that it be no less than $5,000. The owner may add, if the contract allows, to the initial amount invested any time prior to the start of annuity payouts (prior to annuitization, in other words). The company guarantees that when the annuitant reaches the age of their choice the insurance company will send the contract owner a fixed dollar amount for as long as the person lives. In some payout options, each side is gambling. The contract owner is gambling that he or she will live long enough to make a substantial profit; the insurance company is gambling that the annuity owner will die soon enough for the company to make a profit. There are generally multiple payout options available. Some guarantee that the principal and interest will be paid out to someone: either the contract owner or a listed beneficiary. Others stop paying at the death of the annuitant.

 

  Until an annuity is annuitized, the annuity will be paying a rate of interest which may vary greatly from company to company.  The interest accumulating will be tax deferred. Tax deferred says it clearly: taxes are deferred (not avoided). That means that someday taxes will have to be paid on the interest earned. The annuitant will not be taxed on the interest earned, however, until such interest earnings are withdrawn.

 

  There was a time when it could be stipulated that principal was withdrawn first to further delay tax payments; no longer. Amounts received, which are allocable to an investment made after August 13th, 1982, in an annuity contract entered into before August 14th, 1982, are treated as received under a contract entered into after August 13th, 1982, and are subject to the interest first rule (IRS Sec. 72(e)(5). Therefore, it is no longer possible to withdraw the principal first.

 

  To the extent the amount received is greater than the excess of cash surrender value over investments in the contract the amount will be treated as a tax-free return of investment. These amounts are, in effect, treated as distributions of interest first and only second as recovery of cost. Of course, annuities are also penalized by the IRS if they are withdrawn prior to the age of 59½. The amount of the penalty is 10 percent. If funds are withdrawn while the contract is in the early years, there may also be a penalty imposed by the insurance company.

 

  Money may be withdrawn prior to annuitization. Many contracts allow 10 percent per year to be withdrawn without any penalty being imposed by the insurance company. It is not necessary to ever actually annuitize the contract. Many people never do annuitize their contracts. Taxes are paid on the taxable portions of the annuity (the interest earnings) for the year in which they were received. When the contract is annuitized the insurance company determines the amount to be received in the monthly check. The amount of money that will be received is derived from a formula that uses such factors as age, principal deposited, plus interest earned, and the payout option selected.

 

  There tends to be some standard payout options offered:

1.      Single Life: For as long as the annuitant lives, he or she will receive a check each month for a set sum of money. The amount to be received each month will never change. This option will pay the maximum amount in comparison to the other options. This is the option mentioned previously that involves a gamble. If a person lives a long time, they may collect handsomely over time. If their life is cut shorter than expected, the insurance company will keep any balance left unpaid.  No left-over funds will be distributed to any beneficiaries.

2.      Joint-And-Survivor: Under this option, the insurance company will make monthly payments for as long as either of two or more named people live. This option is often utilized by married couples or other close relatives. Any two people named will be honored by the insurance company. Both of the people's ages are considered by the insurance company when determining what the monthly payments will be set at.

3.      Life and Installments Certain: The key word here is certain. The "certain" period of time is usually either ten or twenty years but may be another time period also. This option states that should the annuitant die prior to the stated "certain" time period, payments would then continue to the beneficiary until that specified number of years has been met.  On the other hand, the annuitant may receive payments longer than the "certain" period stated. That is where the life part comes in.

4.      Cash Refund Annuity: If the annuitant dies before the amount invested has been paid out by the insurance company, then the remainder of the invested money (plus interest earned) will be paid out in monthly installments, or in a lump sum, to the named beneficiaries.                                                                                                                  

 

  In each of these options, the insurance company pays nothing beyond the agreed period of time.  Therefore, as a recap:

·         SINGLE LIFE = nothing is paid after the death of the annuitant;

·         JOINT-AND-SURVIVOR = nothing is paid after both named people have died;

·         LIFE AND INSTALLMENT CERTAIN = nothing is paid after the death of the annuitant or until the stated time period, whichever comes last; and

·         CASH REFUND = nothing is paid after the full account has been paid out whether to the annuitant or a beneficiary.

 

  On all of these options, nothing beyond the terms of the contract would be paid to the estate.  Remember that an annuitant could live to be extremely old and still receive monthly income equaling far more than the amount ever actually paid into the annuity. Unfortunately, many people never realize that annuities, while marketed by life insurance companies, are actually the opposite of life insurance. Annuities pay in life while life insurance is designed to pay at death.

 

  While all types of annuity contracts tend to have these basic options in them, there are various annuity models from which to choose, which are somewhat of a repeat of the basic types of annuities. However, annuity models are variations of the basic types available.

 

  ACCUMULATION DEFERRED ANNUITY: This model is often used by young people who need time to be able to save.  Rather than depositing one lump sum of money into the annuity, they agree to make regular installments for a minimum period of time.

 

  SINGLE PAY IMMEDIATE ANNUITY (SPIA): A lump sum of money is paid to the insurance company and annuity payments begin right away (generally 30 days from the date of deposit). Realize that this option gives up the tax shelter that deferred annuities offer. The  annuitant may elect to actually annuitize their contract or they may simply elect to take the interest earnings, never actually annuitizing the contract at all.

 

  VARIABLE ANNUITY: The main difference between a fixed annuity and a variable annuity lies in who takes the investment risk. When a fixed annuity contract (policy) is annuitized, the insurance company commits to a fixed monthly amount of money that they will pay no matter how long the annuitant may live. The company has invested the money in a number of income producing vehicles and expects that their investments will produce enough income to both make the payments and provide a profit for the company. With the variable annuity, the company guarantees to pay an unchanging percentage of the value of an unchanging number of investment units. In other words, the annuitant is taking the risk rather than the insurance company.  Often the units are shares of a mutual fund. This is not generally considered to be a high risk since insurance companies tend to be conservative investors. Even so, it would be wise to investigate what types of investments the company being considered tends to make. Normally, the chances are that the units will increase in value. However, there is no guarantee of this. The annuity could, if the investments do not experience growth, experience losses instead of gains.  Even so, many investors prefer to use variable annuities since they tend to pay better than fixed annuities.

 

  WRAP-AROUND ANNUITY: These are sometimes called Switch-Fund Annuities. As insurance products go, this is a relatively new concept (and a seldom used concept). A life insurance company joins a mutual fund organization managing several mutual funds with different goals and different investment policies. The insurance company provides the annuity contract, and the mutual fund company provides the investments. This type of annuity gives the policyholder the freedom to specify which of the mutual funds are desired.

 

  In 1982, the IRS issued a tax restrictive ruling on the wrap-around annuities. This ruling applies only to specific types and uses of annuities; not the general annuity purchased by the majority of consumers.

 

Wrap-Around Annuity aka Investment Annuity

  The Internal Revenue Service may also refer to the Wrap-Around Annuity as an Investment Annuity. "Investment Annuity" and "Wrap-Around Annuity" are terms for arrangements under which an insurance company agrees to provide an annuity, funded by investment assets, placed by or for the policyholder with a financial custodian. The assets are placed in a specifically identified investment (the mutual fund). It is normally held in a segregated account of the insurer. IRS has ruled that, under such arrangements, sufficient control over the investment assets is retained by the policyholder so that income (interest) on the assets prior to the annuity starting date are currently taxable to the policyholder rather than to the insurance company. With the exception of certain contracts grandfathered under Rev. Rul. 77-85 and Rev. Rul. 81-225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the regulations (IRS Sec. 817(h). Again, we must stress that most annuity purchases are tax deferred. When funds are withdrawn, the interest is taxed on nonqualified annuities; the entire amount withdrawn is taxed on qualified accounts.

 

  In the last few years, we have also seen a number of annuity products developed that are very much like a Certificate of Deposit or CD. The volatility of the stock market, lowering interest rates and the mess of the savings and loan industry provided a perfect climate for such products.

 

CD-Like Annuities

  The many factors seen today often produce what is referred to as "investment stress." Simply put, investors do not trust anyone at all. Consequently, it has become increasingly important to develop financial portfolios that include some type of middle ground for their assets.  These investment products must also provide guarantees of principal, a fairly competitive interest rate and reasonable access to the investment funds. Certainly, the investment must also contain a very minimum level of risk. Insurance companies, in response to this marketplace, have developed what is called CD-Like Annuities. These annuities are a hybrid of the single premium deferred annuities (usually referred to as SPDAs). However, the CD-like Annuities give the policyowner the liquidity and rate of return most often seen with traditional Certificates of Deposit that are marketed by the banks. Unlike CDs, however, these annuities have all the advantages of single premium deferred annuities, which includes tax-deferred growth, guarantees of principal, and the opportunity to convert the account value to a guaranteed income for life or specified period of time. Usually, the commission base is lower for CD-Like Annuities in comparison to other annuity products.

 

  As most agents realize, all single premium deferred annuities are designed to be used as tax-deferred investments for the long-term. CD-Like Annuities are geared for a shorter period of time. They normally offer longer guaranteed interest periods as well. Some of the CD-Like Annuities may also allow additional deposits. They may allow partial penalty-free withdrawals from the account during a specified option period, too. The additional deposits and the withdrawal options are often referred to as "windows of opportunity." The most common CD-Like Annuities run for periods of either one, three or five years. The Window of Opportunity generally lasts for 30 days after each guaranteed interest period.

 

  Certainly, the largest selling point of such CD-Like Annuities is the tax-deferred growth with liquidity coming after a relatively short period of time. For many clients, their assets have always been kept at the local bank in the traditional Certificates of Deposit that their bank offers.  Being able to offer such clients a similar product that grows tax-deferred is a way of introducing them to the world of annuities. After the client is comfortable with the investment advantages offered by annuities, the consumer may venture into longer lasting annuities (with longer maturity periods) to gain higher interest earnings.

 

  In past years, annuities were sold primarily on the basis of the rate of interest paid. All too often, the more important features of the annuity seemed to be ignored. In today's financial climate, the rate of interest is often the least important feature to the client.

 

 

  Starting an annuity especially makes sense when time is on the investor's side. Due to penalties from both the IRS (prior to age 59½) and possible penalties imposed in the early years by the insurance companies, it is sometimes considered a "forced" retirement fund once started. Depending on who is looking at this feature, this could be considered either a plus or a minus.

 

  Once retirement comes, there are some decisions to be made regarding the annuity. Generally, the retiree annuitizes at this point and begins to receive their monthly checks. This is not always the best choice. If the check that will be received each month does not compare well with a yield that can be obtained elsewhere, the money should perhaps simply be withdrawn, the tax paid, and the money reinvested elsewhere. The insurance company can advise the annuitant how much the monthly income would be.

 

  Another reason the retiree may not wish to annuitize their annuity has to do with life expectancy. If neither the husband nor the wife would live long enough to get a good return before death, it may be wiser to simply draw off the 10 percent allowed each year without any penalties.  Once annuitized, this option is no longer available. Also, if at retirement, the money in the annuity is not needed, then certainly it may not be wise to annuitize. The longer the money is tax-deferring the better off the annuitant may be depending upon their financial situation. When annuity pay-outs begin, the tax shelter ends. The bottom line is simple: look at all options available before locking into any one option.

 

 

Individual Retirement Accounts (IRA)

 

  Individual Retirement Accounts are usually simply referred to as IRAs. IRAs could be considered the common man's do-it-yourself pension plan. Until 1981, IRAs were for people who did not participate in a company's pension plan. As of January first, 1982, IRAs became available to nearly everyone, although there are earning restrictions regarding tax deductibility.

 

  The Economic Growth and Tax Relief Reconciliation Act of 2001 changed the contribution limits on the Traditional, Roth and Education IRAs.  An individual could contribute up to $3,000 per year to their Traditional or Roth IRA from 2002 to 2004. It rose to $4,000 from 2005 through 2007 and $5,000 in 2008. After 2008, the $5,000 limit was adjusted annually for inflation. In 2018, the contribution maximum for traditional and Roth IRA plans reached $5,500. By increasing the contribution limits to an IRA (which can carry attractive tax advantages) the government hopes to encourage retirement savings. As we often hear, those who retire without having saved anything themselves tend to end up being supported, to some degree, by the taxpayers. With this idea in mind, it is easy to understand why the government wishes to encourage retirement investing.

 

  For those who have attained age 50, the law allows “catch-up contributions.” In 2025, the catch-up contributions allowed $3,500 extra to be contributed.  

 

 Under a change made in SECURE 2.0., a higher catch-up contribution limit applies for employees aged 60, 61, 62, and 63 who participate in SIMPLE plans. For 2025, this higher catch-up contribution limit is $5,250.

 

 https://www.irs.gov/newsroom/401k-limit-increases-to-23500-for-2025-ira-limit-remains-7000

 

  Individuals covered by a retirement plan at work, such as a 401(k) plan, the income ranges for IRA deduction phaseouts changed in 2025 as follows:

·         For single taxpayers with a workplace retirement plan, the deduction is phased out for those making $79,000 to $89,000, up from $77,000 to $87,000.

·         For married couples filing jointly, where the IRA contributor is covered by an employer’s plan, the income phaseout range rose to $126,000 to $146,000, from the previous $123,000 to $143,000.

·         Finally, for couples where the individual contributor is not covered by a plan, but their spouse is, the income phaseout range climbed to $236,000 to $246,000 from the previous $230,000 to $240,000,

 

  How does a deductible IRA work? Most people understand the basics but may fail to realize how deeply the advantages extend. Suppose a person with a yearly gross income of $20,000 puts $1,500 into a Traditional IRA. The individual would pay income taxes on $18,500 rather than the full $20,000 earned ($20,000 less $1,500 = $18,500). If the individual were in a 25 percent tax bracket, this would amount to a savings of $375 in taxes to begin with. In addition, the IRA would earn interest without experiencing taxation (until withdrawal). With a Traditional IRA, both the amount deposited, and the interest earned is tax deferred. Few people seem to realize how large a benefit this is. Taxation draws off a large portion of the realized gains in an investment vehicle. Over 20 or 30 years, the difference between an investment that is taxed yearly and one that is tax-deferred is dramatic.

 

  The wider the spread happens to be between an individual's tax bracket while working and the tax bracket at retirement, the more valuable an IRA is.

 

  IRAs may be placed in a variety of investment vehicles. Annuities are one of the investment vehicles often used for IRA funds. Certificates of Deposit probably see the largest quantity of IRA deposits, but as people become more aware of the options, the balance may well shift.

 

  Once an IRA has been initiated, the money deposited should not be withdrawn until age 59½.  To do so before that age would bring about stiff penalties from the Internal Revenue Service, usually 10 percent of the amount withdrawn. In addition, in the early years, the holding institution may also levy penalties for early withdrawals.

 

  As with so many tax-deferred vehicles, the earlier one begins to save, the better off they will be.  Interest and time work exceptionally well together. The reason for this lies in compounding power. Compounding power means both the original deposit and the interest it has earned continues to earn additional interest.

 

 

  Although an IRA may be "rolled over" in order to avoid IRS penalties, there may be penalties imposed by the institution for early withdrawal, even if that withdrawal is in the form of a roll-over. If a roll-over is being considered, for whatever reason, this factor needs to be considered.

 

  Some institutions may also impose various fees under an assortment of names. They may be called management fees, accounting fees and so forth. Whatever label is placed on the fees, they rob the IRA in the end. The Internal Revenue Service Disclosure Statement can be used as a comparison shopping tool to some degree. Any reluctance on the part of the institution to supply this statement should raise a red flag for the consumer.

 

 

Company Ratings

 

  It can be very difficult for the consumer to sort through all of the various ratings given an insurance company. The important question is "Do you, as an agent, understand it?" It is not unusual for even an experienced agent to feel uncomfortable with much of the financial terminology.

 

  As we know, agents have an ethical obligation to accurately describe the financial strength (or weakness) of the insurance company being represented. This is true of an insurance policy being proposed or replaced. In fact, it has been held that an agent has a legal obligation to accurately describe such financial data. A lawsuit could be brought against an agent who causes a client to suffer financially as a result of the agent's failure to fulfill these "due diligence" responsibilities.

 

  Overall, most agents wish to give their clients the best products available. Certainly, a career agent would want to do so simply to remain in business. Often, it is the agent's lack of understanding or inattention to some of the technical terminology used in documents pertaining to the financial strength of insurance companies that causes the agent problems down the road.  In other words, many agents either do not understand or fail to read much of the material that is available regarding the companies they deal with. Terms such as admitted assets, consolidated assets, projected mortality, plus many other terms, are not completely understood. The agent may have a vague idea of what the terms mean, but not enough of an understanding to properly assess the companies. Certainly, much of the printed material available is not stated in a way that makes the information easily readable.

 

  Many of the terms used are associated with the company's balance sheet, its statement of assets, liabilities, and the owner's equity.

 

  Admitted Assets are those assets the company is allowed by state regulatory authorities to include in its statutory annual balance sheet. Some of a life insurance company's assets may be excluded in the interest of balance sheet conservatism, although most assets are admitted. If an asset is a non-admitted asset, it is generally regarded by regulators as a bit less sound than admitted assets. Non-admitted assets are typically thought to provide less security for the company's policyholders. Non-admitted assets include such things as the agents' balances owed to the company, office furniture, and mortgage loan interest income that is overdue by more than a specified length of time.

 

  Consolidated Assets are the total of the assets of the parent insurance company and all the subsidiary companies if more than 50 percent of the voting stock is owned. Even though the assets are owned by two or more separate companies, for the purpose of the balance sheet, the assets are combined and treated as if they were owned entirely by the parent company. This is due to the voting control the parent company has. Even the assets of subsidiaries not engaged in the life insurance business are included in the consolidated assets of the parent company.

 

  Investment Grade Issues are an item often seen in percentage form. These are bonds whose insurers have been evaluated by a recognized rating agency that has placed them in one of the agency's few highest quality rating classifications. Generally speaking, the higher this percentage is, the greater the safety of the bonds in the portfolio. Even so, the rating assigned to any particular bond issue can be lowered without warning as a result of many circumstances or events.

 

  It is common for insurance companies to advertise that their assets exceed large quantities of money. A company may advertise, for example, that their assets exceed $2 billion. While it is important to have sufficient quantities of assets, the amount of those assets will mean nothing if the company's liabilities equal or top the amount of assets. The size of a company’s assets is less important than the percentage of the company’s liabilities in relation to those assets. There is a basic balance sheet equation: assets = liabilities + owner’s equity.

 

  All three components must be considered before the strength (or weakness) of a company can be correctly judged.

 

  Owner’s Equity is the amount of the insurance company's assets that are financed with funds that were supplied by owners rather than by creditors.

 

  Contingency Reserves are accounts (from owners' equity) that are voluntarily set aside by the insurance companies for the possibility of unforeseen future adverse circumstances.  Usually, the board of directors will not pay dividends from these reserves.

 

  Unassigned or Permanent Surplus is the amount of the mutual insurer's owners' equity that has not been set aside for any specific reserve or purpose.

 

  Common Stock that is referred to in financial statements are the total number of shares of common stock outstanding. They are usually valued at an arbitrary (and usually low) dollar amount. This may be called par or stated value per share.

 

  Additional Paid-In Capital or Contributed Surplus is the same thing. It is the excess of the selling price of the stock at the time it was issued over its par value. Neither the amount of the capital stock account nor the additional paid-in capital account has any relationship to the present value of the stock life insurer's common shares.

 

  A balance sheet also contains a section on the company's liabilities. The largest amount listed will be for amounts owed to policy owners and the beneficiaries of the life insurance policies.  There may be (though not always) the normal borrowed funds and accrued expenses payable.

 

  Mandatory Securities Valuation Reserve is also generally listed in the liability section. This is a reserve (as the name implies) of some of the assets (not necessarily cash) which are set aside to prevent changes in the amount of the company's unassigned or permanent surplus, which may result from fluctuations in the market value of other assets such as bonds, preferred stock, and common stock.

 

  Even though the Mandatory Securities Valuation Reserve is listed in the liability column of the balance sheet, it is not a true liability. It is more like a reserve for amounts owed to others. State regulatory authorities decide the size the reserve must be, which is determined by a number of factors.

 

  Capital Ratio is the portion of the company's total assets that are financed by the owner's funds. This is often the measure used to determine the insurance company's financial strength.  It may also be called Capital-To-Assets Ratio, or Surplus-To-Assets Ratio. The higher this percentage is, if all other things are basically equal, the greater the company's financial strength is thought to be. Note that the previous statement said: "if all other things are basically equal."  Since the Capital Ratio is so often used to compare the financial strength of companies, it is important to realize that different ingredients may be used in determining the ratio.

 

  Sometimes an insurance company will make reference to its income statement as a basis of financial strength. Income is only part of the picture, of course. A company's direct premium income does not show any premium income or outlays resulting from reinsurance transactions, for example.

 

  Net Premium Income is typically defined as its direct premium income plus premiums it earns from reinsurance it assumes, minus premiums it gives up due to reinsurance that it transfers to another company.

 

  In other words:

Direct premium income

PLUS

Premiums earned from the reinsurance it assumed

MINUS

Premium it gives up due to reinsurance it cedes to other companies

EQUALS

Net Premium Income.

 

  Even though this formula may be used by an insurance company to suggest its financial strength, it really is only about half of the needed information to make a sound judgment call. In fact, it is more likely to tell an agent the size of the company rather than its financial strength.

 

  Surplus Reinsurance is the transfer of a portion of the amount of coverage under a life insurance policy to a reinsurer. The ceding or surrendering company is then allowed, if regulatory requirements are met, to also transfer to the reinsurer a corresponding portion of the aggregate reserve liability under the policy. The ceding company receives a credit against its liability for the portion transferred.  Some feel the use of surplus reinsurance may be a sign of an insurance company's financial weakness.

 

 

  The terms from the balance sheet that we have discussed here generally are overlooked by many agents. Typically, agents are more concerned with a company's rating from the rating firms, such as A.M. Best. That information is certainly important and is easier for the agent to obtain and understand. It is also probably easier to relay to a potential client in a sales situation.  However, it is becoming increasingly evident that such rating firms are not infallible. There are also differing opinions among rating firms. Which one is the correct rating? Which rating firm do you believe? There have been insurance companies who have enjoyed a high rating that have ended up in financial difficulty. A career agent simply must look beyond the rating of a company.

 

  Some states have noted that agents tend to ignore such things as balance sheets when their state has a guaranty fund. Not all states have such funds. Many agents probably are not aware that such state guaranty associations typically cover only the guaranteed values of the policy, not the projected, assumed, or illustrated values. Of course, if a company is in financial trouble, the client is probably glad to simply get anything at all.

 

  There are so many things that play a part in an insurance company's financial strengths. Things such as underwriting procedures and standards, how it sets up reserves, risk spreads, management, and reinsurance practices are a few of the things that will affect its financial strength. An agent cannot know all that is involved in a company, but an agent can look past the surface of the brochures. Remember that any given company is selling itself not only to the policyholders, but to the agents who market their products as well.

 

  Realizing that insurance companies are selling to the insurance agents (so that the agents will sell their products), an agent can take a common sense approach to due diligence. For a busy agent, it can be difficult to follow through on all financial details involved in an insurance company's financial report. While the technical analysis is certainly important, such analysis is not always possible.

 

  When using a common sense approach to determine financial solvency, there may be a combination of factors to consider. A company that makes one or more obviously big financial mistakes may end up with financial problems. The companies that invested in junk bonds, for instance, now know what a big mistake that was financially. Although junk bonds looked good at the time, there was no lack of warnings from the professionals about potential risk involved.

 

  Watch out also for losses within a company that exceed the gains.  While this may occasionally happen, it is most definitely a warning signal. Losses eat up capital and surplus funds. In fact, if money is going out faster than it is coming in, as in all businesses, a red flag should go up.

 

  Sometimes a lack of public trust can cause problems. If the consumers perceive a problem within a company, they may begin to withdraw funds or quit paying premiums. A company that is trying to hang on may be pushed over the edge when such consumer concerns affect it.

 

  Perhaps the best common sense approach is simply looking at the products being offered. If any given product seems to give too much in relation to other companies, something may be wrong, either with the company's philosophy or with its managing staff. There may be much more commission being offered, or product design may reveal gimmicks rather than sound policy benefits.

 

  If a company is not a mutual company, then it is often a good idea to know who owns the company. Consumers tend to view an insurance company as an "entity," when it is actually very much like other companies: someone owns it. The company's owner or owners will reflect their own values and ethics throughout the company itself. While it may not be possible to know what the values and ethics are of any given person, the agent can look to their past history. Do they come from the insurance field? What past financial education do they have? If they were in management for another company previously, what was their performance history?

 

  The object of using these common sense approaches is not necessarily to find the best companies, but rather to weed out the worst of them. An alert insurance agent must keep their eyes and ears open. Listen to other agents. Follow the service given to clients from the home office. Does service start out well, but then steadily decline? Are calls answered promptly, or is it difficult to reach the home office?  Is the home office set up to discourage agent or client calls?   These are signs of problems within the company. While it may be something as simple as a poorly managed service department, it may also be something as major as an entire company ran poorly.

 

  Probably every agent alive has run into the client that is sure that he or she knows more than you do. Generally, what it really amounts to is an underlying mistrust of the industry as a whole.  Such people will often bring up the "pending disaster" stories, or the ones that make insurance agents and companies out to be money-hungry crooks. We cannot change everyone's attitude, but we can use good judgment so that others do not join these people in their opinions.

 

  Some have compared the insurance industry to the savings-and-loan industry, which is absolutely not a valid comparison. The financial strength and condition of the insurance industry (especially the life insurance portion) is one of the most financially solvent industries in the United States. As Frederick L. Huber, the administrator and assistant to corporate counsel of Brokers Marketing Service in Los Angeles pointed out, the insurance industry have never been subsidized by the taxpayers. This helps maintain the stability of the insurance industry.

 

  Certainly, there is concern in any industry if the number of insolvencies dramatically increases.  We may see more of that in the insurance industry due to some recent natural disasters such as hurricanes and flooding. These failures will be primarily in the Property & Casualty field.

 

  There is one area where many businesses, including the life insurance industry, have attempted to divert attention. In the past, debt levels were highly stressed. We are now seeing the emphasis placed more on returns and profitability. An S&L may boast about the amount of deposits they have. What they fail to mention is that deposits are actually liabilities, not assets. An insurance company may flaunt the amount of insurance in force. Again, this is a liability, not an asset.  Financial strength is based upon assets and profitability.

 

 

  The persistence of in-force policies is one of the best indicators of strong products and good service.  Persistency is a measure of marketing strength and service effort. It is also a measure of how well the agents have matched products to a client's needs. This last aspect comes back to company training.

 

  In the end, no matter how good the company or investment vehicle is, it must fit the client's ethics, financial needs, and personality. All these factors must be considered.

 

  Life insurance sales can be a rewarding occupation for those who take the time to apply the fundamentals correctly. This requires knowledge, skill, and dedication. Those agents who apply these qualifications will find a financially rewarding career.

 

 

End of Chapter 9