Life insurance: Dispelling illusions

CPA Journal, The, Sep 2001 by Godfrey, Joseph E III

Be sure to read the fine print

In Brief

There's No Magic, Only Magicians

Purchasing life insurance has never been, and never will be, fun, Nevertheless, it is important-especially for the high-nel-worth individual who must provide liquidity for estate planning purposes. To put the purchasing decision in perspective, the author presents a brief history of life insurance, explaining the developments that have led to today's array of products. Their variegated evolution means certain inevitable compromise that an advisor can illuminate and some salesmen may obfuscate.

Purchasing (or advising the purchase of) life insurance involves the careful considerations of current and future financial circumstances and a studied observation of the policy's provisions. A successful policy benefits both the insured and the insurer. Only by properly understanding all the pluses and minuses of the myriad policies and provisions available can a wise purchase be made.

Most people, especially CPAs and other financial professionals, think they know what "life insurance" is. But what does it really mean? First, it's not really life insurance. It's "death insurance." It's the promise of an insurance company to pay the face amount (the initial death benefit, which may change over time) upon due proof of the death of the insured and the surrender of the policy with a properly completed claim form.

One of the facts of life is that people don't want to think about death-especially their own-which is why this contractual promise is called life insurance. Today's life insurance is the product of a long history of continuous change and has become substantially more useful as a result.

Brief History of Life Insurance

"[L]ife insurance as we know it ... began in the 19th century ... Industrialization-with its cities, factories, money economy, and an urban 'saving' class-set the stage for life insurance as a large-scale, national institution. Life insurance, it can truly be said, is a product of modern industrial society. [Davis W. Gregg and Vane B. Lucas, "A Brief History," Life and Health Insurance Handbook (1973)]

The first life insurance company in North America, the Presbyterian Ministers' Fund, was established in 1759. The Insurance Company of North America, chartered in 1794, was the first commercial enterprise to sell policies; it sold only six policies in five years and discontinued operations in 1804.

The insurance business took off in the 1840s because of the confluence of the rapid growth of the US industrial economy, the start of mutual companies, and the development of the agency system of distribution. The in-force level rose to $97.1 million by 1850, and $173.3 million by 1861. Numerous companies failed during the general depression of the mid-1870s, and by 1882, only 55 of 129 survived. By 1970 there were around 1800 companies, but today there are hundreds fewer, because of failures, consolidations, and mergers and acquisitions. Today, most life insurers are stock companies owned by shareholders. Fraternal companies make up a very small piece of the total pie, and only a small number of the mutual companies remain as such. The primary allegiance to the policyowner is the most obvious competitive advantage that a mutual company has over a stock company.

Risk Assessment and Ratings

The cost of life insurance protection is based on a number of factors used by the actuary in pricing the product. The home office underwriter collects and reviews the prospective insured's personal information for these factors in order to obtain a clear picture of risk. These underwriting and actuarial factors include:

* Age

* Sex: Women typically live longer than men, so their rates are lower.

* Smoker status: Actuarial data prove that cigarette smokers die at a younger age, so their mortality charges are higher; cigar and pipe smokers are treated variously.

* Health history: A family history of early deaths due to cancer, heart disease, or stroke will affect mortality.

* Face amount: People have an unlimited insurable interest in their own life; as a practical matter, carriers and their reinsurers do have aggregate upper limits, which cap out around $150 million on an individual life or second-to-die basis.

* Motor vehicle record: Speeding tickets and drunk driving arrests could presage an early demise.

* Vocation: Some jobs are riskier than others.

* Avocational pursuits: Sky diving, hang gliding, mountain climbing, scuba diving, auto or motorcycle racing, and private flying can increase the risk of an early death.

* General reputation and personal character.

Once these items are all reviewed for their plusses and minuses, the insured is assigned to an underwriting risk category. Thirty years ago, the only variables affecting the premium were age, sex, and face amount. Now carriers primarily rely upon age, sex, and tobacco use; then other items are reviewed to further categorize the risk. Most carriers now have three to seven risk categories. Although there are different names and requirements at different companies, some examples from a five-- point scale (illustrated in Exhibit 1) include: