Life Insurance Accounting: Strategies For Success

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. It can be used as a financial asset during one's life and to provide financial support to loved ones after death. There are two main types of permanent life insurance that can be used as an asset: whole life insurance and universal life insurance. Life insurance premiums are typically considered personal expenses and thus are not tax-deductible. However, if a policy has a cash surrender value, it can be included as an asset on a personal balance sheet.

Understanding the different types of life insurance

Term Life Insurance

Term life insurance is designed to provide coverage for a specific number of years. It is a temporary policy with a set expiration date, usually offered in terms of one, five, 10, 15, 20, 25, or 30 years. This type of insurance is ideal for individuals who need affordable coverage during a particular period, such as while raising children or paying off a mortgage. Term life insurance is generally the most affordable option and offers a guaranteed payout if the insured person dies during the policy term. However, if the policyholder outlives the term, their beneficiaries will not receive any payout.

Whole Life Insurance

Whole life insurance is a type of permanent life insurance that provides coverage for the insured's entire life, as long as they continue to pay the premiums. It offers a fixed death benefit and a fixed monthly premium that remains the same throughout the policy. Whole life insurance also includes a savings component, allowing the policyholder to accumulate cash value over time. This cash value can be borrowed against or withdrawn, providing flexibility for the policyholder. While whole life insurance is typically more expensive than term life insurance, it offers the advantage of guaranteed coverage for life.

Universal Life Insurance

Universal life insurance is another form of permanent life insurance that offers coverage for the insured's entire life, as long as premiums are paid. It is similar to whole life insurance but provides more flexibility. Universal life insurance allows the policyholder to adjust the death benefit and premium payments within certain limits. It also includes a savings component that grows over time and can be borrowed against. The interest rate on the cash value of a universal life policy is not fixed and may vary based on market conditions.

Variable Life Insurance

Variable life insurance is a riskier type of permanent life insurance. It consists of a fixed death benefit and a variable cash value component that is tied to the performance of selected investments. The cash value can rise or fall based on the policyholder's investment choices. Variable life insurance offers the potential for higher returns but also carries a higher risk. It is suitable for individuals who are comfortable with investing and want more control over their policy's growth.

Final Expense Life Insurance

Final expense life insurance, also known as burial or funeral insurance, is a type of whole life insurance designed to cover end-of-life expenses, such as funeral costs, medical bills, or outstanding debt. It offers a smaller and more affordable death benefit compared to other types of life insurance. Final expense life insurance is typically easier for older individuals or those with health issues to qualify for, making it a good option for those who may not qualify for other policies.

Other Types of Life Insurance

In addition to the main types mentioned above, there are several other variations of life insurance, including short-term life insurance, indexed universal life insurance, supplemental life insurance, and more. These policies cater to specific needs and circumstances, such as providing coverage for a very short period or offering additional coverage beyond an employer's group life policy.

Knowing how to account for life insurance as an individual policyholder

As an individual policyholder, it is important to understand the different types of life insurance available and how they can be used as a financial asset. Life insurance is a legally binding contract between an insurance company and a policy owner, where the insurer guarantees to pay a sum of money to the named beneficiaries when the insured person dies. The two main types of life insurance are term life insurance and permanent life insurance. Term life insurance is designed to last for a certain number of years and then end, while permanent life insurance stays in force until the insured person's death, provided the policyholder continues to pay the premiums.

Permanent life insurance, including whole life insurance and universal life insurance, can be used as a financial asset during the lifetime of the policyholder. These policies allow the owner to build cash value over time, which can be accessed through loans, withdrawals, or by surrendering the policy. The cash value of permanent life insurance serves as a savings account, accumulating on a tax-deferred basis. It is important to note that life insurance premiums are typically considered personal expenses and are not tax-deductible. However, if a policy has a cash surrender value, it can be included as an asset on a personal balance sheet.

When considering life insurance, it is crucial to evaluate your financial situation and determine the coverage amount required to meet your needs and goals. Factors such as age, gender, health, lifestyle, and family medical history can impact the cost of life insurance premiums. Additionally, the policyholder should periodically reassess their life insurance needs, especially after significant life events such as marriage, the birth of a child, or the purchase of a house.

Understanding the different types of life insurance and their features will enable you to make an informed decision about the coverage that best suits your circumstances. Consulting with a financial professional can provide valuable guidance in navigating the complexities of life insurance and ensuring that your policy aligns with your financial objectives.

Knowing how to account for life insurance as an insurance company

Knowing how to account for life insurance is essential for insurance companies to ensure compliance with financial regulations and provide accurate information to policyholders. Here are some key considerations and steps for insurance companies to effectively account for life insurance:

Understanding the Basics

Insurance companies need to recognise premium revenue over the term of the insurance contract. This involves calculating and recording the income from policyholders' premium payments. It's important to note that premium revenue is typically recognised over time rather than all at once.

Future Policyholder Benefits

Insurance companies must also calculate and record a liability known as "future policyholder benefits". This represents the present value of expected future payments to policyholders. It is essential to accurately estimate and update these benefits as they are a crucial component of the insurance company's obligations.

Deferred Policy Acquisition Costs

Insurance companies should establish an asset called "deferred policy acquisition costs". This represents the costs incurred in acquiring new policies, such as commissions and underwriting expenses. These costs are capitalised and recognised over the term of the insurance contracts. By doing so, insurance companies can better manage their expenses and ensure that acquisition costs are appropriately allocated.

Regulatory Compliance

Accounting for life insurance is subject to rules and standards set by financial regulators and bodies such as the Financial Accounting Standards Board (FASB) in the US. Insurance companies must stay updated with the latest regulations and ensure their accounting practices comply with these standards. This helps maintain transparency and protect the interests of policyholders.

Tax Considerations

The tax treatment of life insurance policies can be complex and vary based on specific circumstances. It is crucial for insurance companies to consult with tax professionals or experts to ensure proper tax handling, including any tax liabilities or deductions associated with premium revenue or policy benefits.

Internal Processes and Controls

Insurance companies should implement robust internal processes and controls to manage life insurance accounting effectively. This includes establishing clear guidelines for recognising revenue, calculating liabilities, and allocating acquisition costs. Additionally, having a robust internal audit function can help identify and address any discrepancies or errors in accounting practices.

Disclosure and Transparency

Insurance companies have a responsibility to provide clear and transparent information to policyholders about their life insurance policies. This includes disclosing relevant accounting practices, such as how premium payments are recognised and how future benefits are calculated. This promotes trust and ensures policyholders understand the financial aspects of their policies.

Periodic Review and Updates

The insurance industry is dynamic, and regulations and accounting standards can change over time. Insurance companies should conduct periodic reviews of their life insurance accounting practices to ensure they remain compliant and up-to-date. This helps them adapt to any changes in the regulatory environment and maintain the accuracy of their financial reporting.

Understanding the tax implications of life insurance

Life insurance proceeds are typically not taxable as income. However, there are several situations in which you or your beneficiaries may be taxed on some or all of a policy's proceeds.

Taxation on proceeds

If your beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit. In this case, your beneficiary would have to pay income tax on the interest.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that period.

If the policyholder names an estate rather than an individual as a beneficiary, the person or people inheriting the estate might have to pay estate taxes. In the US, the federal estate tax exemption limit is $13.61 million for an individual. If the payout causes your estate's worth to exceed this amount, your heirs might be charged estate taxes.

Taxation on cash value

Whole life insurance and most other permanent life insurance policies earn cash value over time, which you can withdraw or borrow against. For the most part, this cash is tax-deferred, meaning you only pay income taxes on it if you withdraw funds from the policy. And even then, the IRS levies a tax only on the amount that exceeds the policy basis—this is the sum of what you’ve already paid in premiums, minus any dividends you receive.

If you surrender a permanent life insurance policy, you’re essentially cancelling the coverage, and the insurer pays out the policy’s cash value, minus any surrender fees. The portion of the cash value that exceeds the policy basis is taxable.

Taxation on dividends

If you have permanent life insurance from a mutual insurance company, you may receive periodic dividends from the company. Unless the amount of money you receive in dividends exceeds the amount you’ve paid in premiums, life insurance dividend payments are not taxable.

Taxation on settlements

If you no longer need your life insurance policy, you may be able to get a life insurance settlement. In this case, a third party pays you a certain amount of money to become the policyholder and beneficiary, and they take over paying premiums. When you pass away, the third party would have to pay taxes on the life insurance death benefit. However, they don’t pay income taxes on the entire amount. The taxable amount would be the death benefit minus the value of whatever was paid to you, as well as any amount paid in premiums since they acquired the policy.

As the seller, you would also be subject to taxes on the sale of your life insurance policy. A portion of the life insurance settlement is taxable as income, and the rest is taxed as capital gains.

Taxation on premiums

If you have an individual policy, life insurance premiums are not tax-deductible. They’re treated the same as any other expense.

Group term life insurance policies, typically provided by an employer or association, are different. The employer can deduct life insurance premium payments for up to $50,000 of coverage per employee, as long as the employer is not the beneficiary.

Avoiding taxes on life insurance proceeds

To avoid paying any taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity. One way to do this is to set up an irrevocable life insurance trust (ILIT). You transfer ownership of the policy to the ILIT and cannot be the trustee. However, you can determine who you want as the trust beneficiary.

Knowing how to use life insurance as a financial asset

Understanding Life Insurance as an Asset

Life insurance is typically thought of as a safety net for loved ones in the event of the policyholder's death. However, certain types of life insurance policies can also serve as valuable financial assets during the policyholder's lifetime. These policies allow the owner to build cash value over time, providing access to funds that can be utilised in various ways.

Types of Life Insurance Policies that Serve as Assets

Not all life insurance policies are created equal when it comes to their potential as financial assets. Generally, only permanent insurance policies, such as whole life insurance and universal life insurance, fall under this category. Term insurance policies, which are less expensive and valid for a set number of years, do not offer the ability to accumulate cash value that can be accessed.

Whole Life Insurance

Whole life insurance is the most common type of permanent life insurance. It offers a death benefit and allows the policyholder to accumulate cash value over time. A portion of the monthly premium is allocated to a cash value account, which grows at a guaranteed minimum rate. Whole life insurance premiums typically remain stable throughout the life of the policy.

Universal Life Insurance

Universal life insurance functions similarly to whole life insurance, allowing policyholders to accumulate an asset by earning interest over time. However, universal life policies have variable premiums and do not guarantee a specific rate of return. Additionally, "variable universal life insurance" offers policyholders the ability to invest their earnings into accounts of their choosing, providing the potential for higher returns.

Using Life Insurance as a Financial Asset

Life insurance policies that serve as financial assets offer several ways to maximise their potential:

• Taking a loan from the policy: You can borrow against the cash value of your permanent life insurance policy, but be mindful of the interest rate and any outstanding balance at the time of your death, as it will be subtracted from your beneficiaries' inheritance.
• Using the policy as collateral: Your life insurance policy can serve as collateral for a loan, potentially making it easier to obtain approval or secure a better interest rate. However, any unpaid balance at the time of your death will be deducted from the benefits paid to your beneficiaries.
• Withdrawing funds: You may be able to withdraw funds directly from your policy, but be aware that withdrawals from investment gains may be subject to taxes, and the amount withdrawn will reduce the value of the policy and the subsequent benefits.
• Accelerated benefits: Some policies offer the option to receive benefits during your lifetime if you experience an unexpected or extreme medical emergency, such as cancer or a heart attack.
• Surrendering the policy (cashing out): Cancelling your coverage will allow you to retrieve the cash value you have built up, minus any fees charged by the insurance company. This option should be carefully considered, as fees may be high, similar to early withdrawal penalties from a retirement account.

Key Considerations

When shopping for a life insurance policy that can serve as a financial asset, it is essential to focus on policies that offer a cash value component. Additionally, consult with financial professionals, such as a J.P. Morgan advisor or a certified public accountant, to navigate the complex tax implications and regulations surrounding life insurance policies.

Frequently asked questions