Life Insurance Basics
Pricing and purpose
Life insurance transfers the risk of premature death to an insurer, which pools many similar risks. Premiums rest on three factors: mortality (expected deaths, driven by age and health), interest (earnings on invested reserves), and expense (commissions, administration, taxes). A level premium charges more than the cost of protection in the early years so the policy can fund the rising cost of insurance later.
Measuring the need
Two standard approaches: human life value (present value of the insured's future earnings) and needs analysis (income replacement, debts, education, final expenses, minus existing resources). Field underwriting begins with a complete, accurate application.
Tax treatment you must know
Death benefits are generally income-tax-free to the beneficiary. Cash value grows tax-deferred; policy loans are not taxable events unless the policy lapses or is surrendered. Dividends are a return of premium - not guaranteed, and not taxable until they exceed the owner's basis. A modified endowment contract (MEC) fails the seven-pay test; withdrawals are then taxed LIFO with a 10% penalty before age 59½. Transfer-for-value rules can make death proceeds taxable.
Traps
Exams love: dividends are guaranteed (false), the death benefit is taxable income (false), individual premiums are deductible (false), and cash value grows tax-free (it is tax-deferred).
Rule of thumb
Term is pure protection and the lowest cost per dollar of face amount. Permanent is protection plus a savings element; the shorter the premium-paying period, the higher the annual premium.
Worked example
A client needs $500,000 of coverage for 20 years - level term is the economical match; a permanent policy is justified only if lifelong coverage or cash accumulation is a stated goal.