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Life Insurance and Annuities

It is not often that the topics of life insurance and annuities are brought up in the same discussion, primarily because they serve two very distinct purposes. Although they are both products of life insurance companies, life insurance policies are protection against dying too soon, and annuities are protection against living to long. However, when utilized in the context of a complete financial plan built on a solid foundation of family and financial security, the two work hand-in-hand to protect the complete circle of life.

Life Insurance as a Capital Creator

The basic premise of life insurance is that most people, throughout their financial lives, have obligations and expenses that need to be paid, both now and in the future. In the earlier stages of life, these are funded through cash flow and accumulated savings. But, when a person dies too soon, these obligations and expenses are usually left unpaid because not enough time has passed to be able to accumulate the capital needed. For instance, an outstanding debt, say of $10,000, is paid down through monthly payments. When a person dies, the outstanding balance is left unpaid.

Or, if a family is saving for college, and has only accumulated a portion of the required funds when one of the primary breadwinners dies, the future obligation is unfunded, and the likelihood of continued savings towards to goal is diminished.
Life insurance becomes the source of the much needed capital to fulfill these obligations and pay down debt. Essentially, it replaces the income earning capacity of a breadwinner and ensures that the family can continue to maintain the lifestyle to which it is accustomed, which is why it is important to accurately assess the financial needs of the family in order to have enough protection.

Life insurance is used as a capital creator in any instance where an untimely death could leave a family, a business or an estate in a precarious financial position. If a fledgling business were to lose a key person or partner, it could suffer a devastating financial loss. Life insurance provides the capital a business needs to maintain continuity while searching for a replacement or rebuilding client goodwill. When a person dies and leaves a sizable estate, life insurance provides the liquidity the heirs need to pay estate settlement costs and taxes so that assets don’t have to be forced into liquidation.

Annuities as a Capital Protector

In the later stages of life, after savings and assets have been accumulated, annuities serve to protect this capital so that it can be preserved for future use. The unique characteristics of annuities combine to create a shield of protection that allows the capital to accumulate while guaranteeing its full return to investors. Additionally, annuities will protect the distribution of the capital to ensure that it will fully fund a lifetime income stream without interruption or loss of value.

Annuities are also issued by life insurance companies as a contract much like life insurance policies, except that they insure individuals against the possibility of living too long and outliving their income sources. When a person transfers a portion of his assets to an annuity, it can be left to accumulate, or it can be converted to income (annuitized). In either case, the principal balance is guaranteed as is the minimum rate of interest.* Annuities provide an extra measure of capital preservation by allowing the earnings inside to accumulate without being taxed currently, although they will be taxed when they are eventually received.

Once an annuity begins to make periodic payments, the principal balance is committed, irrevocably, to the life insurer who then commits to making the payments until all of the principal and interest earnings have been fully distributed – over a specific time period, or for the life of the individual.

The payments, which are fixed (except in the case of variable annuities in which payment amounts can fluctuate based on market fluctuations), are based on the amount of the original principal balance, the project earnings from interest, and the number of payment periods. Individuals, who rely upon their assets for their income, often use annuity income to inject stability and predictability into their overall income portfolio that may also consist of more risk oriented assets.

Businesses use annuities when they need to fund installment payments or an income stream as part of a compensation arrangement with a key person, or as a funding vehicle in a buy-out situation.

Life Insurers as Circle of Life Protectors

Life insurance and annuities are both issued by life insurance companies. Both provide a form of protection that entails the risk of mortality for which the cost is actuarially calculated by the life insurer. In both cases, those costs are borne by the individual in the form of a premium. In both cases, the life insurer must calculate the amount of reserves it needs to have on hand to be able to pay all future obligations, either as death benefit proceeds or as annuity income payments (or surrenders).

The financial strength and stability of life insurers is paramount to the ultimate security of life insurance and annuity policyholders. The safety track record of life insurance companies dates back two hundred years during which there has not been one instance of a failure to fulfill an obligation to a policyholder. While there have been some cases of life insurer insolvency, the number is miniscule as compared to the banking industry which has recorded hundreds of failure in just the last few years. In most of the life insurer insolvencies, the assets and obligations of the insurers were assumed by a larger or financially stronger life insurance company.

Summary

In peoples’ financial life, the need to create capital and preserve it is essential to meeting their most important obligations and providing the financial security all families need. No other financial instrument can create capital as quickly or as inexpensively as life insurance and no other financial product can preserve capital and guarantee its complete distribution over a lifetime like annuities. For most people a complete financial plan will include both if their current and future financial security is a priority.
*In some variable annuity contracts the principal and minimum rate guarantees are options that require additional premiums.