Life insurance provides income tax free lump sum benefit at the time of an insured’s death. The purchase of life insurance provides coverage for a family against the risk of a premature death of a breadwinner. For a family, the concept of human capital value is an economic term which represents the present value of an individual’s expected income earned over their lifetime. For a business, the concept relates to the contributions an individual makes towards a business profits. In both instances, there is an anticipated economic loss if an individual dies prematurely which would result in catastrophic losses which need to be insured. Life insurance proceeds are designed to provide cash liquidity to the owner or beneficiaries of the policy at the time of the insured’s death. The two main types of life insurance policies are:
The insurance policies are funded over a certain term or for an insured expected lifetime depending on the intended purpose for the insurance. The life insurance premiums are projected costs over a specified period or lifetime. These projections are either guaranteed or subject to increase if the projections are not met. Life insurance premiums reflect the risk of premature death based on an insured’s life expectancy. Life expectancy is based on an insured’s age, gender and health. Medical underwriting is required for most life insurance policies that may require a medical examination by a physician for life increase policies with large face amounts. Insureds with shorter life expectancies because of health, vocational or occupational risks are considered impaired risks that require specialized life underwriting. Guaranteed issue policies are available for lower face amounts at greater premiums.
The owner of a life insurance policy must have an insurable interest in the life of the insured. An insurable interest is held by a family member, employer, business partner or estate of the insured. The insurable interest requirement avoids any potential moral hazards form the insured and adverse selection for the insurance company. A policy owner can continue maintain ownership of the life insurance policy after the insurable interest has expired. There is a secondary market for the sale of life insurance policies, after an insurable interest has expired, to a third party. This secondary market transaction creates a “stranger-owned” life insurance policy which represents an investment for the new owner. The life insurance proceeds become taxable to the investor with the costs basis represented by the purchase price and subsequent premiums paid by the second policy owner.
