Group Term Insurance Part 2 of 2

Introduction

In this part, we will look at how the Compensation & Benefits Specialist usually determine how much term insurance to buy. Before that, we will look at the role term insurance plays in small businesses. After that, we will examine the question of assigning beneficiaries to the insurance proceeds. I also want to introduce trauma insurance, which I felt is more important than term insurance, which is subject to employer abuse.

Term Insurance for the Small Business Owner

Small businesses used term insurance to protect the business in the case of the pre-mature death of an active owner.  The life insurance proceeds

  • Provide the fund a buy-sell agreement, that is purchase the deceased partner’s interests.
  • Provide an income stream for the surviving family.
  • Provide financial cushion to provide for the loss of an active owner. This buys time to replace an owner.
  • Provide cash to equalize the inheritance of a family, where only 1 of the children inherits the company.
  • Provide the money to pay estate taxes so that the company need not be sold to pay the tax liability.

Key Man Insurance

Before the popularity of term insurance as a benefit for all employees, businesses also buy term insurance to protect the business against the loss of a key employee.

  • “Key Man” insurance is a life and/or disability policy taken out by the business as a beneficiary in the event of death or disability to a particular key employee. This type of policy is also called key executive coverage, key person coverage and key employee coverage.
  • The policy works by paying the business in the event of the death or disability of a person who is so important to the business that their loss could destroy the business. The policy is a cheaper option than standard life or disability policies because the policy can be purchased with a “first to die” provision and cover multiple key employees.
  • The employer buys the policy and pays all the premiums with after-tax dollars. If the employee dies, the employer receives the entire death benefit tax-free under normal circumstances. The business then uses the proceeds to compensate for lost revenue that the employee can no longer earn, and to find, hire and train a suitable replacement.

Determining How Much Group Term Life Insurance to Buy

Broadly speaking, there are 2 ways of determining how much group term life insurance to buy

  • Providing a flat amount of cover for everyone. This can be (a) a dollar amount, such as $100,000 (b) a number of times of the base salary, such as 12 OR 24 times (c) a percentage of the basic annual salary, for example 125% of basic annual salary, rounded to the next highest $1,000 or $50,000, whichever is less
  • Providing different amount of cover for different cluster of employees, such as  CEO and heads of departments; managers and supervisory staff, staff in general.

Which Is The Correct Method?

The difficulties with determining the amount of term coverage based on the number of times of the salary is that this is an simplified method. It fails to take into account each employee’s individual needs and obligations. You may buy too little coverage or more coverage than what you want to provide – the top management staff who can afford to buy their own term insurance is covered heavily by the company, while those in junior positions and who are most likely not able to provide ample insurance for themselves, will be under protected.

My preference would be to use a flat rate for all. It reduces discrimination. It serves objective of proving protection. It is administratively easier to maintain and renew.

The objective of providing the benefit is to provide needed financial assistance to the employee’s immediate family in the case of his or her death. At this moment, I am not aware of any suitable reference to determine what, how much and what length of period term insurance should be. The key question is affordability, on the part of the company.

Employee should regard group term insurance as a supplemental life insurance policy. The payout is not enough to truly take care of a family for very long, if the major breadwinner is lost. After funeral expenses, the payout of  one to two year’s salary of the deceased individual may not amount to a great deal of money for many people.

Background on Insurance Policy Beneficiary Designation

Unlike permanent life insurance policies, term life insurance policies allow the beneficiary to claim the death benefit only if the insured person dies before the term of the policy expires. The beneficiary, who is entitled to receive compensation on the death of the insured person, is known as the primary beneficiary. In case the primary beneficiary dies before the insured person, the contingent beneficiary has the right to claim the death benefit. A single beneficiary is called a specific beneficiary. In case a group of people are named as beneficiaries, they are known as class beneficiaries. If the policy owner wants a minor to be the recipient of the life insurance benefit, a guardian who has the legal authority to receive the death benefit, should be specified in the will. Most life insurance policies give the policy owner the right to revoke the beneficiary named in the policy. In case of irrevocable beneficiaries, the beneficiaries’ consent is needed in order to name a new beneficiary to the policy.

Group Term Life Insurance Beneficiary Designation

The interesting thing about group term insurance is that the company is the owner or holder of the insurance policy. It takes out the policy and pays the premiums. The life assured is the person whose life is insured. In this case the policy is not an “own life” policy since the policy owner or holder and the life assured are different. If it was, the guaranteed death benefit or sum assured will be paid to the deceased’s estate or trust (if one was set up). For a non “own life” policy, the sum assured is paid to the policy owner, in this case the company. Only individuals or companies who have an “insurable interest” can apply for a policy on someone else’s life. “Keyman” insurance are life insurance policies taken out on the key employees with the company as beneficiary.

It is the company’s responsibility to disclose to the employee that they are the insured in the policy and to obtain their consent. A way to do this will be in the employment ontract.

Most company will ask employee to complete a Group Life Insurance Beneficiary Designation Form.

Problems Posted By Beneficiary Designation

There are 4 situations where

First, an employee can name any person or entity they choose as a beneficiary. The beneficiary may be a relative, a friend, an acquaintance, a trust or a charity or a company. The employee can change the beneficiary at any time without the consent of the beneficiary unless they have completed an assignment (if permitted by the policy) or an irrevocable beneficiary designation.

Second, if the employee did not designate a beneficiary or if the designated beneficiary does not survive the employee and there is no contingent beneficiary named, the policy provisions will determine how benefits will be paid. Usually, the money will go to the employee’s estate once the employee is deceased.

Third, the death benefit of many life insurance policies are left unclaimed since the beneficiary is not the policy owner and is unaware of the existence of the policy. In order to ensure that the death benefit does not go unclaimed, the policy owner should inform the beneficiaries about the existence of the policy.

Fourth, a divorce, annulment, or similar event may not invalidate a beneficiary designation that names the employee’s former spouse. To remove the former spouse the employee must submit a new designation. A Power of Attorney cannot change or sign the beneficiary designation form.

Corporate Owned Life Insurance

COLI is life insurance purchased by company for its own use. Keyman insurance is an example. It is different from group life insurance policies.

During the 1980s, large corporations in the United States began taking out COLI policies on hundreds of thousands of workers regardless of how important their skills and expertise were to the overall business structure. Dead peasant or dead janitor Insurance is sometimes used as a shorthand reference for life insurance policies that insure a company’s rank-and-file employees and name the company as the beneficiary.When employees died, the companies enjoyed windfalls because life insurance proceeds are not subjected to taxes. Moreover, companies could borrow against the policies, and then deduct the interest they paid as legitimate business expenses.

Even if the law required employers to disclose the dead peasant policies to insured employees, they can be easily ignored. Because a company’s purchase of insurance policies is not a public record, it is virtually impossible to know every company that invested in policies on employees’ lives. So, the only way a person could learn about the policies was through the employer’s voluntary disclosure.

In the United States, the Pension Protection Act of 2006 contains the COLI Best Practices Provision. It amends the Internal Revenue Code of 1986 by introducing Section 101(j).

Concluding Remarks

Below are 3 interesting things to know about life insurance.

Life Insurance for Retirement and Estate Planning

Term insurance is usually for the young family that is looking for the maximum death benefit. Permanent life insurance is for retirement security and estate protection. It provides a tax-free payout after death and is exempt from estate duties. It does not carry these risks.

  • Tax risk if money is kept in taxable or tax deferred account and if subjected to estate taxes.
  • Investment or stock market risk
  • Liquidity risk – This refers to assets that will trigger a tax, other expenses and loses value when sold suddenly.

Permanent life insurance can be a pension alternative. Life insurance does not pass through a will (thus avoiding will contests). It is not subjected to probate or income tax.

The strategy is to turn taxable money into tax-free money using the tax exemption for life insurance.

Ownership of Life Insurance Policy

An irrevocable life insurance trust is a trust that is set up for the purpose of owning a life insurance policy. If the insured is the owner of the policy, the proceeds of the policy will be subject to estate tax when he dies. But if he transfers ownership to a life insurance trust, the proceeds will be completely free of estate tax. The proceeds will be exempt from income tax either way.

However there are some disadvantages:

  • The insured must give up the right to change the beneficiary of the policy (the trust itself will be the beneficiary). The trustee alone has that right, and the insured cannot serve as trustee of his own life insurance trust. Of course, the insured will designate the beneficiaries of the trust (for example, his children). But because this designation cannot be changed after the life insurance trust has been set up, the insured will lack the flexibility to deal with changed family circumstances with this particular policy.
  • The insured can no longer borrow against the policy.
  • If the policy has not yet endowed, you must find a way to pay the premiums without using up your estate and gift tax exemption.
  • Once you set up and fund the trust, you cannot get the policy back. If you become uninsurable, you will be committed to this trust as your only life insurance.
  • The insured cannot serve as trustee of the life insurance trust. That means that he will have to find or hire a third party trustee.

You may want to know that whether the deceased died domiciled outside or in Singapore, estate duty has been removed for deaths on and after 15 Feb 2008.

Trauma Cover or Critical Illness Insurance

Trauma insurance (also known as critical illness insurance) provides a cash lump sum in the event of contracting a specified disease or trauma. The number of conditions covered (benefits) varies widely, cheaper policies often offering less benefits.

If a person suffers a medical trauma, term life insurance would not help as the person is still alive. Suppose a person has a mild heart attack and is seriously ill but is able to return to work after two months. Will he or she be as productive as before or stand the stress associated with working as hard? Policies like income protection and TPD Insurance may not be suitable since pay-out depend on the effect of the event after its occurrence. What is needed is a cover like trauma insurance which pays out on the actual occurrence of the incident.

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