351 Class Lecture

7/31/2019 351 Class Lecture

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FIL 351

LIFE INSURANCE

Prof. George FlaniganInsurance Industry Professor.


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Life InsuranceSummer 2005 1

HLV Needs Approach

Single People.

Single Parent Families

Two income Earners

Traditional FamiliesBlended Families

Sandwiched Family.


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NEEDS ANALYSIS CHART


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FEDERAL ESTATE TAX

The federal estate tax, also known as a death tax, is a tax

imposed on wealth transfers made at the holders death.

Virtually from the time it was enacted in 1917, there hasbeen pressure for repeal of the federal estate tax.

Congress enacted legislation to repeal the tax in 2000,but President Clinton vetoed the bill.


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PRE-EGTRRA - 2001 ESTATE TAX

The federal estate tax applies to ones taxable estatethe gross estate minus allowable deduction, but any taxpayable is subject to a unified credit that reduces theactual tax payable.

The unified credit was $229,550 in 2001, which exempted$675,000 from the estate tax.

The equivalent exemption was scheduled to increase to$1 million in 2006.


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PRE-EGTRRA - 2001 ESTATE TAX

Estates in excess of the exempt amount were taxed atrates from 37 percent to 55 percent (applicable to estatesin excess of $3 million).

A 5 percent surtax applied to estates from $10 million to$21 million.


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ESTATE PLANNING STRATEGIES

Marital Deduction.

Maximizing effect of unified gift-estate tax credit.

Reduce value of the estate by gifts prior to death.


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PROBABILITIES OF DEATH AND DISABILITIES

Age

Probability of DeathBefore Age 65

Probability of 90-DayDisability Before Age 65

35 22% 50%

40 21% 48%

45 20% 44%

50 18% 39%

55 15% 32%

60 9% 9%


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ELIGIBILITY AND QUALIFICATION

Quarter of coverage one quarter for $870 in earningsin 2002.

Fully insured status 40 quarters of coverage.

Currently insured status 6 of the last 13 quarters.


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FINANCING

FICA tax: originally 1%, 7.65% by 2002 (payable byemployer and employee).

The tax base: originally $3,000, $84,900 by 2002.

Medicare tax is not subject to the wage base. It appliesto total earned income without limit.


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AMOUNT OF BENEFITS

All benefits are based on Primary Insurance Amount(PIA).

PIA is amount to which worker would be entitled for

retirement at age 65.

PIA is based on workers average earnings during

period of employment, subject to certain adjustments.



COMPUTING THE PIA Computation period:

year worker reaches age 22 until year before workerreaches age 62, dies, or is disabled.

Up to 5 years may be dropped. Minimum 2 years incomputation.

Earnings are indexed to determine Average IndexedMonthly Earnings (AIME).

Primary Insurance Amount is computed from AIME byformula.



LOSS OF BENEFITS DISQUALIFYING INCOME

Disqualifying income is not a needs test but aretirement test.

Beginning in 1999, loss of benefits for

disqualifying income applies only to personsunder age 65.

Under age 65, $11,280 was exempt in 2002.

If earnings exceed exempt amount, benefit isreduced by $1 for each $2 the exempt amount isexceeded.



TAXATION OF SOCIAL SECURITY BENEFITS

Amount of benefits subject to tax depends on combinedincome and filing status.

Combined income is the sum of adjusted grossincome, tax exempt interest, and one-half the social

security benefit.

If combined income is between $25,000 and $34,000,up to 50% of social security benefits may be taxed.

If combined income is over $34,000, up to 85% of thebenefits may be taxed.

For those filing joint returns, break points are $32,000and $44,000.



FUTURE PROJECTIONS

Trust funds have increased from about $45 billion in1982 to more than $1 trillion in 2001.

Based on intermediate assumptions, trust funds will

peak at about $3.5 trillion in 2016.

After 2016, deficits will deplete the Trust funds by 2038.



PROPOSALS FOR CHANGE

Change in system of financing.

Change in benefit levels

Original retirement age was 65.

It is scheduled to increase to 67 by 2022. Some have recommended further increase.

Proposal for privatization would allow workers to

invest in private alternatives to social security (i.e.invest in the private sector).



PRINCIPLES OF WORKERS COMPENSATION

Negligence is no longer a factor in determining liability.

Indemnity is partial but final.

Periodic payments are made to workers.

Cost of the program is made a cost of production.

Insurance is required.



OVERVIEW OF WORKERS COMPENSATION LAWS

Persons covered

None of the laws cover all employees.

Most frequently excluded classes are agriculturaland domestic employees.

Laws permit employer of persons excluded to

bring these workers under the law voluntarily.



WORKERS COMPENSATION BENEFITS

Medical Expenses.

Total Temporary Disability.

Partial Temporary Disability.

Total Permanent Disability.

Partial Permanent Disability.

Survivors Death Benefit.

Rehabilitation Benefits.



SOME UNIQUE CHARACTERISTICS OF LIFE INSURANCE

The event insured is an eventual certainty and theprobability of loss increases from year to year.

Life insurance does not violate requisites of an

insurable risk; it is not the possibility of death that isinsured, but of untimelydeath.

No possibility of partial loss. All policies are cash

payment policies.



LIFE INSURANCE NOT A CONTRACT OF INDEMNITY

Principle of indemnity applies on a modifiedbasis in the case of life insurance.

When person taking out the policy is the

insured, insurable interest is not an issue.

every individual has an unlimited insurable interest inhis or her own life.

that insurable interest may be freely assigned.

Persons other than insured must have an

insurable interest only at inception of policy.



TYPES OF LIFE INSURANCE

Term Insurance Cash Value InsurancePure Protection Insurance and Savings

Term Insurance Whole Life Insurance

Endowment InsuranceUniversal LifeInsuranceVariable LifeInsurance



RATIONALE FOR DIFFERENT FORMS

1. Premium eventually becomes unaffordable for person who wants tocontinue coverage:

age 21 $ 1.07

age 30 1.35

age 40 2.42

age 50 4.96

age 60 9.47

age 70 22.11

age 80 65.99

age 90 190.75

2. Insurers developed the principle of the level premium as a practicalmethod of providing lifetime insurance.



COMPARISON OF TERM & WHOLE LIFE PREMIUMS

Level premium reflects anovercharge during the earlyyears of the policy, which isoffset by an undercharge inlater years.

Reserve does not increaseand then diminish, becauseoverpayments by those whodie are forfeited to thereserve for the survivors.

LEVEL PREMIUM

Increasing term

premium



INCREASE IN RESERVE ON WHOLE LIFE POLICY

Decreasing Amountof Protection

Increasing

Savings Element

$1,000

Insureds Age



TAX TREATMENT OF LIFE INSURANCE

Life insurance policies are granted favorable tax treatment intwo ways:

Amounts payable to beneficiary at the death of theinsured are not generally included in taxable income.

Income earned on the cash surrender value is nottaxed until the policy is terminated and the gain isreceived.

Further, the cost of life insurance is deductible as partof the basis in computing taxable gain.



TAX TREATMENT OF LIFE INSURANCE

Favorable tax treatment is allowed only for contractsthat meet the Internal Revenue Codedefinition of lifeinsurance.

Internal Revenue Code establishes two tests todetermine if a contract is life insurance.

If the contract fails to meet one of the two tests,

earnings on the cash surrender value is currentlytaxable to the insured.



CASH VALUE ACCUMULATION TEST

Cash Value Accumulation test will be met if cashsurrender value of the policy does not at any timeexceed the Net Single Premium that is required to fundfuture benefits, assuming maturity no earlier than age95.

Computation uses the greater of a 4% interest rate orthe rate guaranteed by the contract.

CASH VALUE CORRIDOR TEST



PERCENTAGES FOR CASH VALUE CORRIDOR TEST

Insureds AgePercentage

More than Not More Than From To

0 40 250 250

40 45 250 215

45 50 215 185

50 55 185 150

55 60 150 130

60 65 130 120

65 70 120 115

70 75 115 105

75 90 105 105

90 95 105 100


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CURRENT LIFE INSURANCE PRODUCTS

Renewable term: guarantees the insured theright to continue coverage for a number ofadditional periods.

Convertible term: guarantees the insured theright to exchange the policy for some type ofpermanent insurance.

Advantages and disadvantages of term provides greatest amount of protection for

given dollar outlay.

temporary protection only.


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Whole Life

Straight whole life provides protection forinsureds entire lifetime (until age 100) with

premiums payable for lifetime.

Limited-pay whole life provides protection for

entire lifetime (until age 100) with (higher)premiums payable for a shorter time.

Single Premium Life.


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Universal Life

Introduced in 1979 by a brokerage firm.

Subject to specified limitations, premium, cash value,and level of protection can be adjusted up or down tomeet insureds needs.

Premiums are credited to a fund, which is credited with

policys share of investment earnings.

Fund provides source of funds to pay cost of pureprotection (term) under the policy.


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Variable Life Insurance

A whole life contract in which insured has the right todirect how cash value will be invested.

Insured bears the investment risk in the form offluctuations in cash value and amount of protection.

Amount of premium is fixed, but cash value and faceamount vary, subject to a minimum.

Variable universal life combines features of universaland variable life insurance.


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Endowment Life Insurance

Endowment contracts no longer meet the InternalRevenue Codedefinition of life insurance.

Endowment policies are issued for a term period suchas 10 or 20 years.

Endowment policies promise to pay face amount if theinsured dies during the policy period and also to pay theface amount if the insured survives the policy period.


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PARTICIPATING & NON-PARTICIPATING LIFE INSURANCE

Participating policies pay dividends.

Originally issued only by mutual insurers.

Dividend varies from margin built into premium.


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GENERAL CLASSIFICATIONS OF LIFE INSURANCE

Ordinary life 58.8% of insurance in force.

Industrial less than 1% (0.2%) today, compared with10% at one time.

Group life 40% of life insurance in force.

Credit life insurance about 1.2%.

Total life insurance in force exceeds $15 trillion.


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OTHER TYPES OF LIFE INSURANCE

Besides life insurance issued by legal reserve insurers,a small amount (about 2.5%) of life insurance is writtenby other types of insurers.

Savings bank life insurance (NY, Mass, Conn).

Fraternal life insurance.

Veterans life insurance.

Wisconsin state life insurance fund.


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LIFE INSURANCE PREMIUM COMPUTATION

Mortality 1980 CSO Table (separate tables formale/female).

Interest time value of money.

Loading for insurer expenses, taxes, profit.


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COMMISSIONERS 1980 STANDARD ORDINARY MORTALITY TABLE

Males Females

Age

Deaths Per1000

Life

Expectancy

Deaths Per

1000

Life

Expectancy

30 1.73 43.24 1.35 47.6531 1.78 42.31 1.40 46.71

32 1.83 40.46 1.45 45.78

33 1.91 39.54 1.50 44.84

34 2.00 38.61 1.58 43.91


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ONE YEAR TERM POLICY

Alive at age 21 9,810,509

Number who will die: 10,497

1 year term policy without interest:

$10,497,000

9,810,509 = $1.07

1 year term policy with interest

$10,497,780 x 0.95694

9,810,509 = $1.02


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ANNUAL TERM FOR FIVE YEARS

Age 21 $10,497,780 x 0.95694

9,810,509 = $1.02

Age 22 $10,682,000 x 0.95694

9,800,012 = $1.04

Age 23 $10,866,000 x 0.95694

9,789,330 = $1.06

Age 24 $11,147,000 x 0.95694

9,778,464 = $1.09

Age 25 $11,330,000 x 0.95694

9,767,317 = $1.11


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NET SINGLE PREMIUM: 5-YEAR TERM POLICY

Years DeathsAmount of

Claims DiscountPresent Value

of Claims

1 10,497 $10,497,000 0.95694 $10,044,999

2 10,682 10,682,000 0.91573 9,781,828

3 10,866 10,866,000 0.87630 9,521,876

4 11,147 11,147,000 0.83856 9,347,428

5 11,330 11,330,000 0.80245 9,091,890

$47,787,890

5-year term net single premium

$47,787,8909,810,509 = $4.8710


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NET SINGLE PREMIUM: 5-YEAR ANNUITY DUE

Age

Number

Alive Claims Discount

Present Value

of Claims

21 9,810,509 $1 due now $1.000 $9,810,509

22 9,800,012 $1 due in 1 year 0.95699 9,378,023

23 9,789,330 $1 due in 2 years 0.91573 8,694,383

24 9,778,464 $1 due in 3 years 0.87630 8,568,868

25 9,767,317 $1 due in 4 years 0.83856 8,190,481

$44,912,264

5-year annuity due premium

$44,912,2649,810,509 = $4.5779


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NET SINGLE PREMIUM: WHOLE LIFE POLICY

Age Deaths

Amount of

Claims Discount

Present Value

of Claims

21 10,497 $10,497,000 0.95694 $10,044,999

22 10,682 10,682,000 0.91573 9,781,828

23 10,866 10,866,000 0.87630 9,521,876

** ***** ****** ***** *****

99 30,698 30,698,000 0.03087 947,647

$1,052,972,752

Whole Life net single premium

$1,052,972,7529,810,509 = $1.07.33


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NET LEVEL PREMIUM CONVERSION

$4.5779 is the actuarial equivalent of

$1 now and a $1 payment.

every year for 4 years.

Therefore,

$4.5779 : $4.8710 = $1 : X

X = $1.064


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RESERVE ON LIFE INSURANCE POLICIES

Reserve = Present Value of - Present Value of

Future Benefits Future Premiums


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POLICY RESERVES VARIOUS CONTRACTS


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BENEFIT CERTAIN CONTRACTS

Benefit Certain Contracts are those under which, if theinsured persists in premium payments, the policy willeventually mature and benefits will be payable.

Cash value policies, under which benefits are payablewhether the insured lives or dies are benefit certaincontracts.

Ignoring the interest on premiums paid, the net singlepremium on benefit certain policies equals the face ofthe policy.


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BENEFIT UNCERTAIN CONTRACTS

Benefit uncertain contracts are those under which, if theinsured persists in premium payments for the entire policyperiod, the insurer may or may not be obligated to make

payment.


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One year term rate

AgeNumberDying Claims

DiscountRate

DiscountedClaims

NetPremium

21 10 $10,000 .90 9,000 $ 9,000/1,000 = $ 9

22 20 20,000 .90 18,000 18,000/990 = 18.18

23 30 30,000 .90 27,000 27,000/970 = 27.83

24 40 40,000 .90 36,000 36,000/940 = 38.29

25 50 50,000 .90 45,000 45,000/900 = 50.00


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Five year term rate

Age

Number

Dying Claims Discount Rate Discounted Claims Net Premium

21 10 $10,000 .90 9,000

22 20 20,000 .80 16,000

23 30 30,000 .70 21,000

24 40 40,000 .60 24,000

25 50 50,000 .50 25,000

95,000 95,000/1000=$95.00


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Five Year Endowment

Age Dying Claims Discount Rate Discounted Claims Net Premium

21 10 10,000 .90 9,000

22 20 20,000 .80 16,000

23 30 30,000 .70 21,000

24 40 40,000 .60 24,000

25 50 900,000 .50 450,000

520,000 $520,000/1000=$520


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Five Year Annuity due

AgeNumber

Alive Claims Discount Rate Discounted ClaimsNet

Premium

21 1,000 $1,000 1.00 1,000

22 990 990 .90 891

23 970 970 .80 776

24 940 940 .70 658

25 900 900 .60 540

3,865 $3,865/1000=$3.865

Annual premium 5-year endowment:

3.865: $1 = $520: XX = $134.50


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GENERAL PROVISIONS IN LIFE INSURANCE CONTRACTS

Entire contract clause.

Ownership clause.

Beneficiary clause.

Incontestable clause.

Misstatement of age clause.

Grace period clause.

Reinstatement clause.

Suicide clause.

Aviation exclusions.

War clause.


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OWNERSHIP CLAUSE

Ownership rights

right to assign or transfer the policy.

right to receive cash value and dividends.

right to borrow against the policy.

Usually, the insured is the owner.

In the event of the death of the insured, the beneficiary

becomes the owner.


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INCEPTION OF THE LIFE CONTRACT

If the application is submitted without the initialpremium, the insurer makes an offer to the insured andno contract until offer is accepted.

If the initial premium is submitted with the application,the insurer acknowledges receipt of the premium with aconditional binding receipt.

Conditional binding receipt makes the policy effective atdate of application if the applicant is found to have metthe insurers underwriting standards.


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BENEFICIARY DESIGNATIONS

Primary Contingent

Revocable Irrevocable


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REINSTATEMENT

If a lapsed policy has not been surrendered for its cash

value, it may be reinstated within 5 years from the dateof lapse.

Reinstatement requires that the insured

provide evidence of insurability. pay overdue premiums plus interest.

reinstate any indebtedness with interest.


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SETTLEMENT OPTIONS

The interest option.

Installments for a fixed period.

Installments for a fixed amount.

Life income options.

TABLE 14 1 Installments for a Fixed Period


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TABLE 14.1 Installments for a Fixed Period

Minimum Monthly Installments for Each $1000 of Net Proceeds

Period(Years)

MonthlyPayment

Period(Years)

MonthlyPayment

Period(Years)

MonthlyPayment

1 $84.65 11 $9.09 21 $5.56

2 43.05 12 8.46 22 5.39

3 29.19 13 7.94 23 5.24

4 22.27 14 7.49 24 5.07

5 18.12 15 7.10 25 4.93

6 15.35 16 6.76 26 4.84

7 13.38 17 6.47 27 4.73

8 11.90 18 6.20 28 4.63

9 10.75 19 5.97 29 4.53

10 9.83 20 5.75 30 4.45


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LIFE INCOME OPTIONS

Straight life income.

Life income with period certain.

Life income with cash refund.

Life income with installment refund.

Joint and survivor income.


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CHAPTER 14 THE LIFE INSURANCE CONTRACT GENERAL PROVISIONS


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JOINT AND SURVIVOR LIFE INCOME OPTION

Minimum Monthly Joint and Survivor Life Income with Payments Certain for 10 Years per $1000 of Proceeds

Male

Adjusted

Age

Female Adjusted Age

55 60 65 70 75 80 85and over

55 $4.16 $4.34 $4.51 $4.65 $4.76 $4.84 $4.88

60 4.26 4.51 4.75 4.98 5.16 5.29 5.37

65 4.35 4.65 4.98 5.31 5.61 5.84 5.98

70 4.41 4.76 5.17 5.62 6.07 6.44 6.68

75 4.46 4.84 5.32 5.88 6.48 7.03 7.42

80 4.48 4.89 5.41 6.05 6.79 7.52 8.07

85

and over 4.50 4.92 5.46 6.15 6.99 7.85 8.53


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TAXATION OF POLICY PROCEEDS

Benefits under a life insurance policy are not subject to the

federal income tax, except for post-death interest on thepolicy proceeds.

Monthly proceeds for 10 years on a $100,000 death benefitwill be $983, or $11,796 annually.

$10,000 annually is the tax-exempt death benefit.

The $1,796 annually represents taxable interest.

When proceeds are payable under a life income option, thetaxable interest is determined based on the beneficiarys lifeexpectancy using IRS mortality tables.

TABLE OF GUARANTEED VALUES

END OF $100,000


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POLICY CASH PAID-UP EXTENDED TERMYEAR JANUARY 1 VALUE INSURANCE INSURANCE TO

1 1987 $ 0 $ 02 1988 1,078 5,0003 1989 2,201 9,800

4 1990 3,371 14,4005 1991 4,588 18,700

6 1992 5,852 22,9007 1993 7,165 26,8008 1994 8,528 30,5009 1995 9,942 34,100

10 1996 11,411 37,400

11 1997 12,933 40,600

12 1998 14,515 43,70013 1999 16,156 46,60014 2000 17,860 49,30015 2001 19,629 51,900

16 2002 21,466 54,40017 2003 23,370 56,80018 2004 25,341 59,00019 2005 27,380 61,10020 2006 29,486 63,100

AGE 60 2011 38,328 71,800AGE 65 2016 47,545 78,800AGE 70 2021 56,741 84,400


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POLICY LOAN PROVISION

Insured may obtain a loan from the insurer equal to thepolicy cash value.

Loan is subject to a delay clause, up to 6 months.

Interest of 5% or 6% on older contracts, 8% on newercontracts.

Since 1980, NAIC rules allow variable interest rate onpolicy loans.


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DIVIDEND PROVISIONS

Cash.

Applied to payment of current premium.

Purchase paid up additions.

Left to accumulate.


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$500,000 90 LifeFor Joe Client Age 30 Male

Contract Premium $6,210.00Premiums Annual Mo. ISA Annual Income*

@60 $39,084

@65 $64,306

@76 $187,750

Insurance 6,210.00# 540.27 Based on current (2-16-03)

Installment Refund rates & may changeIndexed Protection 370.00 32.19Disability Waiver 150.00 13.05IPB Waiver 85.00 7.40300,000 Accidental Death 216.00 18.80100,000 Additional Purchase 150.00 13.05

Subject to underwriting limits

# Premium included throughout*Non-guaranteed illustrated values and benefits include dividends.Dividends assume no loans;

loans may reduce dividends. Illustrated dividends reflect current (2003 scale) claim,expense and investment experience and are not estimates or guarantees of future results.Dividends actually paid may be larger or smaller than those illustrated.


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DISABILITY WAIVER OF PREMIUM

Insurer agrees to waive all premiums coming dueafter the insured has become totally and permanentlydisabled as a result of sickness or bodily injury.

Disability must commence before some specified age,

usually age 55 or 50, but as high as 65 in somecontracts.

Disability must have lasted for six months.

Premiums are waived from commencement of thedisability, including the first six months.


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DISABILITY WAIVER OF PREMIUM

One of the most important aspects of the disabilitywaiver of premium provision is the definition ofdisability.

Disability usually defined as the inability of the insured to

engage in his or her own occupation during the first twoyears of incapacity.

Thereafter, disability is defined in terms of an occupationfor which the insured is reasonably fitted by education,training, or experience.


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ACCIDENTAL DEATH BENEFIT

Commonly known as double indemnity

Pays an additional sum equal to the face of thepolicy if the death of the insured is caused byaccident.

Death must result, directly and independently of allother causes, from accidental bodily injury and within90 days after the injury.

The accidental bodily injury and death must occurbefore a specified age, usually age 70.

GUARANTEED INSURABILITY OPTION


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GUARANTEED INSURABILITY OPTION

Permits an insured to purchase additional amounts ofinsurance at stated intervals without providing evidenceof insurability.

The customary option dates are at ages 25, 28, 31,

34, 37, and 40. The option amount is limited to the face amount of

the basic policy or a specified option amount,whichever is the smaller.

The maximum amount of each option was originally$10,000, but limits of $25,000 and higher are nowavailable.

COMMON DISASTER CLAUSE


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COMMON DISASTER CLAUSE

Uniform Simultaneous Death Act provides that wherethe insured and the beneficiary have died and there isno evidence that they died other than simultaneously,life insurance proceeds shall be distributed as if theinsured survived the beneficiary.

Where there is evidence that the beneficiary survivedthe insured, even for a short time, the life insuranceproceeds go to the beneficiary and then to his or her

estate.

SPENDTHRIFT CLAUSE


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SPENDTHRIFT CLAUSE

The Spendthrift Clause denies the beneficiary theright to commute, alienate, or assign his or herinterest in the policy proceeds.

Used only in conjunction with an installmentsettlement option.

Provides some protection against the beneficiarys

extravagance that might result in the dissipation of

the policy proceeds.

Also provides some protection against claims madeby creditors of the beneficiary.

COST OF LIVING RIDERS


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COST-OF-LIVING RIDERS

Under a cost-of-living rider, the insurer offers theinsured additional coverage (for which the insured paysan added premium) when the Consumer Price IndexIncreases.

Principal advantage is that the additional insuranceis offered without evidence of insurability.

If the insured rejects any of the increases, the

insurer may require evidence of insurability for thenext increase.

MORTGAGE REDEMPTION POLICY


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MORTGAGE REDEMPTION POLICY

JOINT MORTGAGE REDEMPTION POLICY


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JOINT MORTGAGE REDEMPTION POLICY

Decreasing term, written on two lives.

Designed to cover mortgage obligation of a two-incomecouple in the event one dies.

Premium is slightly less than separate individual mortgageprotection policies on each partner.

SURVIVORSHIP WHOLE LIFE


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SURVIVORSHIP WHOLE LIFE

Also called second-to-die policy.

Insures two lives and pays only at the time of thesecond death.

Designed to cover estate taxes payable at the death ofa surviving spouse, since marital deduction will not beavailable under the federal estate tax.

OTHER SPECIAL POLICIES


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OTHER SPECIAL POLICIES

Return of Cash Value Policy.

Return of Premium Policy.

Family Protection Policy.

Family Income Policy.

Family Maintenance Policy.

MODIFIED WHOLE LIFE


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MODIFIED WHOLE LIFE

Premium for first 3 to 5 years is slightly higher than

premium for term.

At end of 3-to-5 year period, premium increases toslightly more than premium for whole life at inception,

but less than whole life premium at the attained age.

First 5 Years Thereafter

5-year term converted to whole life 4.23 14.99

Modified Whole life 4.58 13.54Convertible Term

GRADED PREMIUM WHOLE LIFE


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GRADED-PREMIUM WHOLE LIFE

Initial premium is quite low, but gradually increases and

levels off sometime between the 10th and 20th year.

Cash values do not develop until year 10 and arerelatively low, even by year 20.


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Graded Premium Whole Life

Modified Whole

LifeWhole Life

SINGLE PREMIUM LIFE


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SINGLE PREMIUM LIFE

Single premium creates an immediate cash value that is sufficient

to fund cost of benefits over the life of the policy.

Written on both traditional whole life and variable life basis.

Rate of return on traditional policies may be guaranteed for1 to 5 years.

Earnings accumulate tax-free until the policy is cashed in.

Usually no front-loaded commission, but subject to surrendercharge that diminishes and disappears after from 7 to 10 years.

Beware corridor rules.

PROTECTION AND CASH VALUE PER $100 PREMIUM


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PROTECTION AND CASH VALUE PER $100 PREMIUM

At age 25, a $100 premium will purchase

CashValue

l Protection in 20 years l

Yearly-renewable term $78,000 $ 0

Ten-year term policy 57,000 0

Whole life policy 11,300 1,671

Paid-up at age 65 10,250 1,695

Twenty-pay life policy 7,400 1,798

BUY TERM AND INVEST THE DIFFERENCE


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BUY TERM AND INVEST THE DIFFERENCE

The choice between term and cash value life insuranceis usually not a risk management decision, it is aninvestment decision.

The choice is not between term and cash value life

insurance, but between cash value life insurance andother investments.

In making this choice, cash value life insurance shouldbe judged against the same standards as other

investments.

LIFE INSURANCE AS AN INVESTMENT


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A considerable amount of literature much from vendors

of competing investments condemns life insurance asan investment.

Much of this literature oversimplifies a complex issue.

There are some situations in which life insurancecompares favorably with other investment alternatives.



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Compulsion: often cited as an advantage but not

particularly compelling.

Tax treatment is more persuasive

Increments to cash value not taxed until received.

Insured allowed to deduct cost of protection incomputing taxable gain.

Complementary function of protecting against

premature death at the same time it provides anaccumulation.

SAMPLE POLICY


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Face Amount $100,000Premium $1,533CV20 $29,48620 x 1,533 $30,660

Net Cost $30,660- $29,486

$1,174 (Net Cost)

Per year $58.70Per year, per $1,000 $0.59

Compare to Cost of Term

Year 35 $2.50 per $1,000Year 45 $4.46 per $1,000Year 54 $7.79 per $1,000

ALLOW FOR TIME VALUE OF MONEY


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PV 1st Premium $1,533.00

PV of following 19 premium + $18,526.79$20,059.79

PV CV in 20 years - $11,112.98 *$8,946.81

Per year $447.34Per year, per $1,000 $4.47

Compare to Cost of TermYear 35 $2.50 per $1,000Year 45 $4.46 per $1,000Year 54 $7.79 per $1,000

*Financial Calculator; Using table 179: 0.37689 x $29,486 = $11,112.98

LIFE INSURANCE AS AN INVESTMENT - NEGATIVES


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LIFE INSURANCE AS AN INVESTMENT NEGATIVES

Life insurance policies have a relatively high expense

component.

Front-loaded commissions make return during earlyyears negative and in the long-run less attractive than

alternatives.

Actual rate of return depends on the time for which thepolicy is held.

If insurance is considered as an investment, it shouldbe considered only as a long-term investment.

MARKETING REFORM IN LIFE INSURANCE


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In the mid-1990s, many segments of the life insurance

industry were subject to extensive criticism for theirmarket conduct.

Headlines referred to practices such as churning,

or improper replacements.

Vanishing premiums that did not vanish.

Misrepresentations during the sales process.

Many insurers were subject to class actionlawsuits and regulatory actions.



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Two areas of concern were illustrations used in marketing

and the replacement of older policies with the newerinterest sensitive contracts.

In response, the NAIC developed new model regulations

to address life insurance marketing practices.

LIFE INSURANCE AND DIVORCE AGREEMENTS


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LIFE INSURANCE AND DIVORCE AGREEMENTS

A divorce proceeding may require purchase of newinsurance or may require continuation of existinginsurance, or the transfer of existing insurancepolicies to a former spouse.

These transactions can have tax implications.

In general, tax treatment of premiums paid for lifeinsurance follow the rules applicable to alimonypayments.

Spouse who is obligated to pay alimony can fundfuture alimony payments through the purchase ofan annuity for the spouse to whom the paymentsare due.

ANNUITIES AND PENSION BENEFITS AND RETIREMENT


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ANNUITIES AND PENSION BENEFITS AND RETIREMENT

ANNUITIES

Reverse application of the law of large numbers.

Lifetime guaranteed income to annuitant.

Persons who live longer offset those who live shorter.

Every payment to annuitant is part interest, part principal,

and part survivorship benefit.

Fixed versus Variable.

Immediate versus Deferred.

Single Premium versus Installment.

Single Life versus Two or More Lives.

Pure Life Annuity versus Annuity Certain.

THE IMPORTANCE OF ANNUITIES


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THE IMPORTANCE OF ANNUITIES

If Roy Peabody is 65 years old, has saved over the

years $200,000, and the current rate of interest is 6%,he has the following options:

OPTION 1

Live off the interest income for the rest of his life and at the time of death hischildren inherit $200,000.

Years Principal Withdrawal

1 200,000 12,000

2 200,000 12,0003 200,000 12,000

4 200,000 12,000

5 200,000 12,000

OPTION 2


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Year Principal Interest Withdraw Remaining From principal

1 200,000 12,000 16,000 196,000 4,0002 196,000 11,760 16,000 191,760 4,240

3 191,760 11,506 16,000 187,266 4,494

4 187,266 11,236 16,000 182,502 4,764

5 182,502 10,950 16,000 177,452 5,050

6 177,452 10,647 16,000 172,099 5,353

7 172,099 10,326 16,000 166,425 5,674

8 166,425 9,985 16,000 160,410 6,015

9 160,410 9,625 16,000 154,035 6,375

10 154,035 9,242 16,000 147,277 6,758

11 147,277 8,837 16,000 140,113 7,163

12 140,113 8,407 16,000 132,520 7,593

13 132,520 7,951 16,000 124,471 8,049

14 124,471 7,468 16,000 115,940 8,532

15 115,940 6,956 16,000 106,896 9,044

16 106,896 6,414 16,000 97,310 9,58617 97,310 5,839 16,000 87,148 10,161

18 87,148 5,229 16,000 76,377 10,771

19 76,377 4,583 16,000 64,960 11,417

20 64,960 3,898 16,000 52,858 12,102

21 52,858 3,171 16,000 40,029 12,829

22 40,029 2,402 16,000 26,431 13,598

23 26,431 1,586 16,000 12,017 14,414

24 12,017 721 16,000 (3,262) 15,27925 3,262 196 16,000 19,458 16,196

Roy has decided that he has had enough of saving for the kids. He wants tolive the good life in Florida, but will require $4,000 more annually to do so.

OPTION 3


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Year Principal Interest Withdraw Remaining From principal

1 200,000 12,000 20,000 192,000 8,000

2 192,000 11,520 20,000 183,520 8,480

3 183,520 11,011 20,000 174,531 8,989

4 174,531 10,472 20,000 165,003 9,528

5 165,003 9,900 20,000 154,903 10,100

6 154,903 9,294 20,000 144,197 10,706

7 144,197 8,652 20,000 132,849 11,348

8 132,849 7,971 20,000 120,820 12,029

9 120,820 7,249 20,000 108,069 12,751

10 108,069 6,484 20,000 94,554 13,516

11 94,554 5,673 20,000 80,227 14,327

12 80,227 4,814 20,000 65,040 15,186

13 65,040 3,902 20,000 48,943 16,098

14 48,943 2,937 20,000 31,879 17,063

15 31,879 1,913 20,000 13,792 18,087

16 13,792 828 20,000 (5,380) 19,172

17 (5,380) (323) 20,000 (25,703) 20,323

Roy decides to move to Florida and discovers the joys of golfand fishing. He figures that he will not live much longer so

$20,000 annually seems like a better retirement income.


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OPTION 5


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Roy decides to buy an annuity. An investment of$200,000 made with Non-Qualified funds will provide an

income under the following annuity options, age 65 male:

Annuity Option Monthly Income AnnualizedIncome

Exclusion Ratio

Life 1,625.62 19,507 51.3%

Cash Refund 1,483.27 17,799 52.2%

InstallmentRefund 1,509.38 18,113 51.3%

10 Year Period

Certain 1,525.10 18,301 79.2%

20 Year PeriodCertain 1,385.51 16,626 60.1%

Joint and 100%to Survive 1,304.58 15,655 51.1%

ANNUITY CERTAIN CONTRACTS


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ANNUITY CERTAIN CONTRACTS

Pure life annuity.

Life annuity with period certain.

Life annuity with installment refund.

Life annuity with cash refund.

SPECIALIZED ANNUITIES


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S C U S

Single-Premium Deferred Annuity

Increased popularity since TRA-86eliminated

many tax shelters.

Currently taxed same as other annuities:earnings accumulate on tax-deferred basis.

Some insurers sell SPDAs with depositpremium as low as $2,500, but morecommon minimum is $10,000.

VARIABLE ANNUITY


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Designed as a means of coping with inflation.

Premiums invested in common stocks or similarinvestments.

Based on assumption that the value of a diversifiedportfolio of common stocks will change in the same

direction as price level.

Variable annuity may be variable during accumulationperiod and fixed during payout period or variableduring both periods.

QUALIFIED RETIREMENT PLANS


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Q

A qualified retirement plan is one that conforms to the

requirements of the Internal Revenue Code (I.R.C.) thatmust be met for favorable tax treatment.

Contributions tax-deductible by the employer

when made.

Contributions and investment earnings bothaccumulate without tax until distributed to the

employee, usually at retirement.

CONTRIBUTORY AND NONCONTRIBUTORY PLANS


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Retirement plans may be noncontributory (entirecost paid by the employer) or contributory (withcontributions added by the employee).

Employee contributions may be voluntary,or they may be required for participation.

Employee contributions not usually deductibleby the employees, but investment income onsuch contributions is not taxed until distributed.

FEDERAL REGULATION OF PRIVATE RETIREMENT PLANS


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The Employee Retirement Income Security Act (ERISA)

of 1974 was the most sweeping overhaul of privatepensions in the history of the country.

ERISA prescribes which employees must be

included in a plan, sets minimum vestingrequirements, specifies contribution limits, andsets minimum funding requirements.

ERISA also requires extensive reporting and

disclosure information about pension and welfareprograms to the Secretary of Labor, the IRS, andto those covered by the plan and theirbeneficiaries.

VESTING REQUIREMENTS


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Vesting refers to the right of an employee to benefits

accrued if employment terminates before retirement.

ERISA requires that a qualified plan meet one of thefollowing schedules:

No vesting for 3 years, with 100% vesting after 3years (called cliff vesting).

20% vesting after 2 years of service, with 20% peryear thereafter, so that 100% vesting exists after6 years of service.

TYPES OF QUALIFIED RETIREMENT PLANS


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Defined Contribution.

Defined Benefit.

Qualified Profit-Sharing Plan.

Keogh Plan.

401(k) Plans.

Employee Stock Ownership Plan.


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PREMATURE DISTRIBUTIONS


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10% penalty prior to age 59 1/2 except for

Deductible medical expenses.

In form of lifetime annuity.

At age 55 by worker who meets plan requirements forretirement.

TAXATION OF DISTRIBUTIONS


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Retirement benefits traditionally paid to participants in

form of a lifetime annuity although many offer lump sum.

Installment distributions taxable only to the extent theyexceed employees investment in the contract.

Lump-sum distributions may be rolled-over into an annuityand taxed under installment rules.

TRADITIONAL INDIVIDUAL RETIREMENT ACCOUNTS


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Anyone with earned income less than 70 1/2 might be

eligible to contribute to IRA account.

Limit is $3,000; spousal is $3,000 as well.

Contributions fully tax deductible if (1) not covered by acompany sponsored or (2) covered by a pension planbut income less than $33,000 ($50,000).

Phase out in 2001: $33,000 - $43,000.

Anyone with income over $43,000 is better off withRoth.

NEW ROTH IRA


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Since January of 1998, contributions permitted to Roth IRA

Contributions made only on a non-deductible basis. All earnings on the contributions compound tax-free as

long as they are not withdrawn for a least five years andthere are no taxes due when the funds are withdrawn forretirement (i.e., after age 59 1/2).

Annual contributions of 100% of compensation up to$3,000 per individual may be permitted.

Single taxpayers with income of up to $95,000 or couplesfiling jointly with annual income up to $150,000 cancontribute full $3,000 annually.

No requirement that withdrawals commence at 70 1/2 and

contributions to a Roth IRA may continue after age 70 1/2if the individual or spouse has earned income.

Individuals can have a Traditional IRA and a Roth IRA, but cannotcontribute more than combined total of $3,000 per year betweenboth of these accounts.

CHAPTER 20


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HEALTH INSURANCE PERILS:

Sickness.

Accident.

HEALTH INSURANCE LOSSES:

Lost income (disability).

Extra expenses (medical expense).


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NEED FOR DISABILITY INCOME INSURANCE


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Probability of disability at most ages before retirement

is greater than the probability of death.

Disability can be both total and permanent. Disabilityranks with death in severity.

When persons other than the disabled person weresupported by the lost income, the problem is moresevere.


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DISABILITY INCOME UNDERWRITING AND PRICING


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Occupational Classes and Underwriting:

Insurers divide risks into three general classes,in descending order of desirability

Professional. White collar.

Blue collar.

In life insurance, group policies tend to bemore liberal; in disability income insurance,

individual policies are generally more liberal.

Taxation: if pay with after tax dollars,payments tax free.

DISABILITY INCOME CONTRACTS: PERILS COVERED


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Accident only generally called accident insurance.

Accident and sickness generally called disability

income insurance.

DISABILITY INCOME CONTRACTS:WAITING PERIODS AND LIMITATIONS


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Waiting Periods in disability income policies act like a

deductible (60 or 90 days)

Insurers generally limit percentage of individualsincome they will insure

About 60% of workers wage under short-term

policies (group).

67% under long-term disability NorthwesternMutual.

To protect against possible malingering.

DEFINITIONS OF TOTAL DISABILITY


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Own occupation.

Own occupation or occupation reasonably suited for onbasis of background, training, experience, or income.

Any occupation: social security definition.

Two-tier definition:

Own (for 2, 5 years, or even until 65); Then any or reasonably suited;

Prime contracts give insured Your Choice, so

after 2, 5 years can stop working altogether (no

more partial, see below) or stop getting benefits; Lesser contract: the claims adjuster determines

whether you can go to work

DEFINITIONS OF TOTAL DISABILITY continued


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Partial disability: insured cannot work as much as

used to before accident and can collect difference(called Loss of Earnings approach).

Pays partial on: earnings now l

pre-loss earning.

DEFINITIONS OF SICKNESS: PREEXISTING CONDITIONS


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Sickness commencing after policy inception.

Sickness first manifesting itself after inception.

Group disability income plans tend to have noexclusions or less restrictive exclusions for preexistingconditions.

Prim individually underwritten contracts check todayand ignore pre-existing condition.

OPTIONAL BENEFIT PROVISIONS


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Guaranteed Insurability Option.

Cost-of-Living Adjustment Benefit.

Waiver of Premium (may be built in).

INDIVIDUAL HEALTH POLICY CONTINUANCE PROVISIONS


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Noncancelable: guaranteed renewable at guaranteed

cost.

Guaranteed renewable: cost can increase but only forentire group in rating category.

Conditionally renewable: only if certain conditions likegood health.

Renewable at company option.

Cancelable.


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SELECTED OPTIONAL PROVISIONS


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Change of occupation changes benefit not in prime.

Misstatement of age changes benefit.

Relation of earnings to insurance reduces benefit ifmaking less than when policy written.

Illegal occupation no coverage.

Intoxicants and narcotics, no coverage.

TAXATION OF DISABILITY INCOME BENEFITS


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Benefits from individual disability income policies not

subject to federal income tax.

Premiums paid by individuals for disability incomeinsurance are not deductible for federal tax purposes.

Sick pay and other disability income payments thathave been paid for by the employer treated as wagesand taxable.

COST OF DISABILITY INCOME INSURANCE


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Premium for disability income depends on

Occupation, age, and sex of the insured.

Period for which benefits are payable.

Amount of the weekly or monthly benefit.

Length of the waiting period.

Most disabilities are short-term; coverage for longer

periods of disability more economical.

Waiting period or elimination period significant

influence on cost.

FEE FOR SERVICE


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The coverage provided by Blue Cross and Blue Shieldand insurance companies came to be called fee-for-service coverage.

Under this approach, insureds were free tochoose doctors, hospitals and other health care

providers, without insurer approval.

The provider and insured agreed on the level ofcare and the insurer would pay some or all of theproviders changes, directly or by reimbursing theinsured.

FEE FOR SERVICE


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Initially, most fee for service plans provided first-dollarcoverage (without participation in cost by the insured).

Eventually, insurers attempted to control costs through

deductibles and share-loss coinsurance, under whichthe patient bears a part of the cost.

MEDICARE


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In 1965, government entered the market when

Congress established the Medicare program to providemedical expense insurance to persons over age 65.

The same legislation created Medicaid, a state-federal

medical assistance program for low-income persons.

During the years immediately following Medicare in1965, the cost of health care (and of private health

insurance) increased dramatically.

MANAGED CARE ORGANIZATIONS


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The solution was the concept of managed care, whichrepresented a change not only in the financing of healthcare, but in its delivery as well.

New types of insurers, such as health maintenanceorganizations, not only provide for the financing ofhealth care, it also delivers that care.

The insurance element in HMOs lies in the way theycharge, called capitation.

In return for a fixed monthly fee, the individual

receives virtually all required medical care, subject toa nominal charge when visiting a physician.


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DOMINANCE OF MANAGED CARE


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HMOs, PPOs, and POS plans all involve anarrangement between the insurers and a network ofproviders and offer insureds financial incentives to usethe providers in the network.

Thirty years ago, 90 percent of insureds had fee-for-service plans.

Today, 32% of employees are enrolled in PPOs,33% are enrolled in HMOs, 17% are enrolled inPOS plans, and 18% are in fee-for-service plans.

ACCESS TO HEALTH CARE


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It is estimated that 44 million Americans have no health

insurance.

About three-fourths of the uninsured areemployees and their dependents

About half of these workers have insuranceavailable at their place of employment but electnot to purchase it.

Some of the uninsureds are unemployed and

about one-third have incomes at or below thepoverty level but do not qualify for Medicaid.

ACCESS TO HEALTH CARE


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The problem of access is not limited to the

economically disadvantaged.

It also exists for persons who are unable to obtain

health insurance in the standard market.

Plans of small employers may exclude coveragefor some employees.

Persons who must purchase insuranceindividually sometimes find that they cannotobtain it.

It is estimated, however, that only 3 percent ofuninsured lack insurance because they areunable to obtain it from a provider.


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COBRA


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Requires continuance of employer-sponsored group

health insurance under specified circumstances

18 months for terminated employees.

36 months for spouses of deceased, divorced, orseparated workers or dependent children whoseeligibility for coverage ceases.

The COBRA participant pays a premium basedon the existing group rate.

TRADITIONAL FORMS OF MEDICAL EXPENSE INSURANCE


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Base Plan Coverage

Hospitalization Insurance

Surgical Expense and

Physicians Expense Insurance

Major Medical Insurance


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EXCLUSIONS UNDER HEALTH INSURANCE POLICIES

Individual policy exclusions tend to be more extensive


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Individual policy exclusions tend to be more extensivethan those in group policies and some group contracts

contain more exclusions than others.

Exclusions typical of those in individual or groupcontracts include:

Expenses payable under workers comp or any

occupational disease law. Personal comfort items (e.g., television, telephone,

air conditioners).

Elective cosmetic surgery.

Routine medical care (e.g., annual physical, birth control,well-baby care).

Hearing aids and eyeglasses.

Dental work.


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LIMITED HEALTH INSURANCE CONTRACTS


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Dread disease policies.

Travel Accident.

SOME SPECIALIZED USES OF LIFE INSURANCE IN BUSINESS


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In addition to their use in fringe benefit programs and

funding retirement benefits, life insurance servesseveral other functions in the business firm:

funding business purchase agreements.

protecting the firm against the loss of a keyemployee.

additional compensation to executives and othervaluable employees.

BUSINESS CONTINUATION INSURANCE


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Death or disability of an owner can create serious

problems for remaining owners.

Ideal solution is to arrange for sale of each ownersinterest prior to death through a buy-and-sellagreement:

cross purchase plan.

entity plan.

Life insurance may be used to fund the buy-and-sellagreement.

KEY PERSON INSURANCE


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An employee who make a significant contribution to

success of the organization is a key person.

Death (or disability) of a key person can be a source ofloss to the organization.

Key person life insurance is designed to compensatefor such loss.

Greatest difficulty in insuring key persons is

determining the amount for which they should beinsured.

DEFERRED COMPENSATION

Employer agrees to make payments to an employee after


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Employer agrees to make payments to an employee afterretirement, or to employees spouse if the employee dies,

if the employee continues his or her employment with thefirm to a specified age.

Employee incurs no federal tax liability on the employers

promise as long as there is no constructive receipt.

Employers often fund deferred comp arrangementsthrough cash value life insurance.


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Questions ??

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351 Class Lecture