Ins301 Chp15 –Part1 1
Life Insurance and Annuities
Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment insurance Whole life insurance Universal insurance Variable insurance
Ins301 Chp15 –Part1 2
Terminology
Death benefit = amount beneficiaries receive Cash value = amount of savings accumulation Death protection = amount of pure death protection
= death benefit - cash value Face amount = stated amount of coverage
= death benefit (for term, whole life, & some universal life)
= death benefit - cash value (for some universal life)
Cash surrender value = the amount of money that the policyholder can withdraw (=cash value - surrender penalty)
Ins301 Chp15 –Part1 3
Life Insurance Products: General Introduction
Term insurance pure life insurance
Cash value life insurance pure life insurance + Savings accumulation whole life universal life variable life Variable universal life
Ins301 Chp15 –Part1 4
Tax Treatment of Life Insurance
Death benefits are not taxed Income tax is not paid on increases in cash value while
the policy is in force Upon surrender, income tax is paid on
Cash surrender value - sum of all premiums
+ sum of all policyholder dividends
Ins301 Chp15 –Part1 5
Implications of Tax Treatment
Implicit returns on savings accumulation Escape taxation if insured dies Tax deferred if the policy is surrendered Partially taxed if policy is surrendered
Amount which is taxed is less than implicit return b/c part of premiums is cost of death protection
Ins301 Chp15 –Part1 6
Term Insurance
Typically provides pure death protection over a fixed term, usually one year or five years. There is no savings feature and therefore no cash surrender value.
Data 1/4 of policies almost half of death protection purchased
Guaranteed renewable Premium increases over time. Why?
Ins301 Chp15 –Part1 7
Life Insurance Pricing
Ignore expenses and risk load ==> focus on net premiums
Use mortality table Probability of dying at age x conditional on living through
age x-1 Example: Probability of male dying at age 40 = 0.00302
Assume Premiums paid at beginning of year Claims paid at end of year
Ins301 Chp15 –Part1 8
Pricing 1-Year Term
Find fair premium for $100,000 1-year term for 40 year-old
Interest rate = 10% Insurer’s cash flows:
Beg. of Year End of Year
$100,000 with prob 0.00302
Loss
$0 with prob. 0.99698
Expected claim cost = ________
Premium = Present value of expected claim cost
= __________
Ins301 Chp15 –Part1 9
Pricing 1-Year Term
Find fair premium for $100,000 1-year term for 41 year-old
Interest rate = 10% Insurer’s cash flows:
Beg. of Year End of Year
-$100,000 with prob ____________
Premium
$0 with prob. ____________
Expected claim cost = ___________
Premium = Present value of expected claim cost= ____________
Ins301 Chp15 –Part1 10
Pricing 1-Year Term
Premium increases as probability of dying increases
$0
$200
$400
$600
$800
$1,000
35 40 45 50 55 60 65 70 75 80 85 90 95
Age
Expe
cted
Cla
im C
osts
Ins301 Chp15 –Part1 11
Pricing 2-Year Term
Find fair premium for $100,000 2-year term for 40 year-old
Insurer’s claim costs:
Beg. of Year 1 End of Year 1 End of Year 2
-$100,000 -$100,000
with prob 0.00302 with prob x
$0 $0
with prob. 0.99698 with prob 1-x
Ins301 Chp15 –Part1 12
Pricing 2-Year Term
What is x? – it is the probability of a 40 year-old dying in his 42nd year?
Mortality table: Number Number
Age of People of Deaths
40 937723 2832
41 934891 3076
Probability of 40 year-old dying in 41st year =_____ = ______
Probability of 40 year-old dying in 42nd year =_____ = ______
Ins301 Chp15 –Part1 13
Pricing 2-Year Term
Single premium
Level Premium
Ins301 Chp15 –Part1 14
Endowment Insurance
Pays face amount if the insured dies, or if the insured survives the policy period
It is similar to a saving account The US no longer grants tax advantage to
endowment policies unless they have a very long duration, such as whole life insurance.
Ins301 Chp15 –Part1 15
Whole Life Insurance
Policy period ends when insured reaches 100 Equivalent to endowment policy to 100 Premiums
single premium limited pay – a level premium paid for a 10-year or
20-year period continuous premium – level premium continue until
the policyholder dies, surrenders the policy, or reaches the age of 100 (whichever comes first)
Ins301 Chp15 –Part1 16
Whole Life Insurance
Premiums generally do not increase over time But probability of dying increases over time
==> higher upfront premiums than with term
Policyholder “prepays” part of the cost of future death protection
entitled to prepayments if policy is surrendered this is the cash value (savings accumulation)
Ins301 Chp15 –Part1 17
Whole Life Insurance
If insured dies, beneficiaries receive face amount
= death protection + cash value
Structured so cash value over time death protection over time
Ins301 Chp15 –Part1 18
Whole Life Insurance
Ins301 Chp15 –Part1 19
Pricing Single Premium Whole Life
Apply same principles used with term insurance Forecast expected cash flows to age 100 Find single premium
= PV of expected cost Assume
no expenses or profits 5% interest rate policy will not lapse
Ins301 Chp15 –Part1 20
Pricing Single Premium Whole Life
Age
Probability of 40
year old dying in
year at left
Expected
claim cost
Present value of
expected claim cost
40 0.003020 $302.00 $302.00/1.05 = $288
41 0.003280 $328.00 $328.00/1.052 = $298
42 0.003538 $353.80 $353.80/1.053 = $306
43 0.003832 $383.20 $383.20/1.054 = $315
44 0.004133 $413.30 $413.30/1.055 = $324
45
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
96 0.004032 $403.20 $403.20/1.0557 = $25
97 0.003098 $309.80 $309.80/1.0558 = $18
98 0.002207 $220.70 $220.70/1.0559 = $12
99 0.001147 $114.70 $114.7/1.0560 = $6
Total 22,373 Single Premium
Ins301 Chp15 –Part1 21
Continuous Level Premium Whole Life
Continuous level premium Same premium is paid until insured dies or reaches 100 Equivalent to a life annuity
Present value of a life annuity that pays $P starting at age 40 = 16.30 * P
Find P so that PV of premium payments = PV of costs 16.30 * P = $22,373 ==> P = $1,372.58
Ins301 Chp15 –Part1 22
Limited Payment Whole Life
Limited payment level premium Same premium is paid for fixed number of years Example: 20 years Equivalent to a 20 year annuity
Present value of a 20-year annuity that pays $P starting at age 40 = $12.58 x P
Find P so that PV of premium payments = PV of costs
12.58 x P = $22,373 ==> P = $1,778.45
Ins301 Chp15 –Part1 23
Comparison of Cash Values in Whole Life
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
$90,000
$100,000
40 44 48 52 56 60 64 68 72 76 80 84 88 92 96
Age
CASh
VALUES
payments for life
20 Year Payments
Single Premium
Ins301 Chp15 –Part1 24
How Much Life Insurance Should be Purchased?
Rules of thumb Death benefit = 8 times income
Forecast beneficiaries sources & uses of funds Uses:
Living expenses Education expenses
Sources: Social security Earnings
Ins301 Chp15 –Part1 25
Participating Policies
Can (and usually does) pay annual dividends always with mutual companies often with stock companies
Why? - premiums based on conservative assumptions Key assumptions: interest rate levels and mortality rates These variables are correlated across policyholders Insurer’s methods of dealing with correlated risk:
Bear the correlated risk and hold a lot of capital Share correlated risk with policyholders
Illustrated versus actual dividends
Ins301 Chp15 –Part1 26
Other Whole Life Policy Provisions
Surrender Options Take cash value Use cash value as a single premium for
paid up whole life term policy
Policy loans borrow against cash value
interest now varies with market rates in 1970s & 80s, fixed rate ==> disintermediation
Front-end expense charges==> Cash value grows slowly at first==> Implicit return on savings accumulation
initially low
Ins301 Chp15 –Part1 27
Universal Life
Similar to whole life Main differences:
Greater flexibility in premium payments Cash value does not follow a fixed schedule; it varies
with policyholder’s premium payments insurer’s expense and mortality charges rate insurer uses to credit interest to cash value
minimum rate usually guaranteed rate often linked to short term interest rates
Ins301 Chp15 –Part1 28
Factors Affecting UL Cash Value
Cash valueat beginning of period
+
Premium paymentsat beginning of period
-
Mortality chargeat beginning of period
-
Expense chargeat beginning of period
+
Interest creditedat end of period
=
Cash valueat end of period
Ins301 Chp15 –Part1 29
Death Benefit Options with Universal Life
Level death benefit (as with Whole Life)
Death benefit varies with cash value
age age
Cash value
Cash value
Death benefit Death
benefit
Ins301 Chp15 –Part1 30
Variable Life
Similar to whole life Main differences:
Cash value does not follow a fixed schedule; it varies with
return earned on portfolio of mutual funds chosen by policyholder
Death benefit minimum is guaranteed, but varies with cash value
Ins301 Chp15 –Part1 31
Life Insurance and Annuities (part3)
What is annuities The purpose of annuity Classification of annuity Overview of annuity contracts
Ins301 Chp15 –Part1 32
What is Annuity
An annuity is simply a series of periodic payments. An annuity contract is an insurance policy that
promises to make a series of payments for a fixed period or over someone’s lifetime
It is typically used as long-term retirement funding vehicles.
Ins301 Chp15 –Part1 33
Two Periods of Annuity
Accumulation period-- the period when the policyholder pays premiums to
the insurer Payout period
-- the insurer makes payments to the policyholder
Ins301 Chp15 –Part1 34
Purpose of Annuity
Risk management purpose Reduce the risk that savings are exhausted before
the annuitant dies tax-deferred saving vehicle
Returns earned from these contracts are not taxed until the insurer distribute them
Ins301 Chp15 –Part1 35
Classification of Annuity
Immediate annuity and deferred annuity Immediate Deferred
Flexible premium deferred annuities (FPDAs) Single premium deferred annuities (SPDAs)
Fixed annuity and variable annuity Fixed annuity Variable annuity
Ins301 Chp15 –Part1 36
Overview of Annuity Contracts
Characteristic Variations
Premium payments (a) Single premium
(b) Fixed period, level premium up to an advanced age
(c) Flexible premium over time
Annuity benefits begin (a) Immediately
(b) Deferred
Annuity benefits end (a) Fixed number of years
(b) Death of one or more individuals
(c) Combination of (a) and (b)
Insurer payments (a) Fixed
(b) Vary with interest rates, with guaranteed minimum
(c) Vary with returns on stock and bond funds chosen by policyholder