General Insurance

Abu khaled

chapter_11.ppt

Home >Business & Finance homework help >General Insurance

Chapter 11

Life Insurance

11-*

Agenda

Premature Death
Financial Impact of Premature Death on Different Types of Families
Amount of Life Insurance to Own
Types of Life Insurance
Variations of Whole Life Insurance
Other Types of Life Insurance

11-*

Premature Death

Premature death can be defined as the death of a family head with outstanding unfulfilled financial obligations
Can cause serious financial problems for the surviving family members
The deceased’s future earnings are lost forever
Additional expenses are incurred, e.g., funeral expenses and estate settlement costs
Some families will experience a reduction in their standard of living
Noneconomic costs are incurred, e.g., grief

11-*

Premature Death (Continued)

The economic problem of premature death has declined because life expectancy has increased

The United States lags behind many foreign countries. Some reasons for this include:
Obesity
Sedentary life style
The purchase of life insurance is financially justified if the insured has earned income and others are dependent on those earnings for financial support

11-*

Financial Impact of Premature Death on Different Types of Families

The need for life insurance varies across family types:
Single people
Single-parent families
Two-income earners with children
Traditional families
Blended families
Sandwiched families

11-*

Amount of Life Insurance to Own

Two approaches can be used to estimate the amount of life insurance to own
The human life value approach
The amount needed depends on the insured’s human life value, which is the present value of the family’s share of the deceased breadwinner’s future earnings

Transparency Master 1.2

11-*

Amount of Life Insurance to Own (Continued)

To calculate the amount needed under the human life value approach:
Estimate the individual’s average annual earnings over his or her productive lifetime
Deduct taxes, insurance premiums and self-maintenance costs
Using a reasonable discount rate, determine the present value of the family’s share of earnings for the number of years until retirement

11-*

Amount of Life Insurance to Own (Continued)

Under the needs approach, the amount needed depends on the financial needs that must be met if the family head should die
The calculation should consider:
An estate clearance fund
Income needed for a one- or two-year readjustment period
Income needed for the dependency period, until the youngest child reaches age 18
Life income to the surviving spouse, including income during and after the blackout period.
Special needs, e.g., funds for college education and emergencies
Retirement needs

11-*

Exhibit 11.1 How Much Life Insurance Do You Need?

11-*

Amount of Life Insurance to Own (Continued)

Internet-based life insurance calculators produce widely varying results, but may be a good starting point
Most families own an insufficient amount of life insurance
Less than half of consumers aged 25-64 own life insurance policies
The average amount of coverage for U.S. adults in 2013 was $167,000, down $30,000 from 2004
Consumers believe life insurance is expensive. They procrastinate, and have difficulty in making correct decisions about the purchase of life insurance

Transparency Master 1.2

11-*

Amount of Life Insurance to Own (Continued)

The opportunity cost of purchasing life insurance may be too high for many families
The purchase of life insurance reduces the amount of discretionary income available for other needs
Many families are in debt and have little savings
After payment of high priority expenses, such as a mortgage, food and utilities, many families have only a limited amount of income to purchase life insurance

11-*

Types of Life Insurance

Life insurance policies can be classified in two general categories:
Term insurance provide temporary protection
Cash-value life insurance has a savings component and builds cash values
There are many variations of both types available today

11-*

Types of Term Life Insurance

Under a term insurance policy, protection is temporary; protection expires at the end of the policy period, unless renewed
Most term policies are renewable for additional periods
Premiums increase at each renewal
To minimize adverse selection, many insurers have an age limitation beyond which renewal is not allowed

11-*

Types of Term Life Insurance (Continued)

Most term policies are convertible, which means the policy can be exchanged for a cash-value policy without evidence of insurability
Under the attained-age method, the premium charged for the new policy is based on the insured’s attained age at the time of conversion
Under the original-age method, the premium charged for the new policy is based on the insured's original age when the term insurance was first purchased
A financial adjustment is also required

11-*

Types of Term Life Insurance (Continued)

Yearly renewable term insurance is issued for a one-year period
Term insurance can also be issued for five or more years
A term to age 65 policy provides protection to age 65, at which time the policy expires
Under a decreasing term insurance policy, the face value gradually declines each year

11-*

Types of Term Life Insurance (Continued)

Under a reentry term insurance policy, renewal premiums are based on select (lower) mortality rates if the insured can periodically demonstrate acceptable evidence of insurability (i.e., good health)
Return of premium term insurance is a product that returns the premiums at the end of the term period provided the insurance is still in force

11-*

Uses and Limitations of Term Life Insurance

Term insurance is appropriate when:
The amount of income that can be spent on life insurance is limited
The need for protection is temporary
The insured wants to guarantee future insurability
However,
Term insurance premiums increase with age at an increasing rate and eventually reach prohibitive levels
Term insurance is inappropriate if you wish to save money for a specific need

11-*

Exhibit 11.2 Examples of Term Life Insurance Premiums

11-*

Types of Whole Life Insurance

Whole life insurance is a cash-value policy that provides lifetime protection
A stated amount is paid to a designated beneficiary when the insured dies, regardless of when the death occurs
Types include:

Ordinary life	Universal life
Limited-payment life	Variable universal life
Endowment insurance	Current assumption whole life
Variable life	Indeterminate-premium whole life

11-*

Types of Whole Life Insurance (Continued)

Ordinary life insurance is a level-premium policy that accumulates cash values and provides lifetime protection to age 121
Premiums are level throughout the premium-paying period
The excess premiums paid during the early years are used to supplement the inadequate premiums paid during the later years of the policy.
The insurer’s legal reserve is a liability that must be offset by sufficient financial assets
The net amount at risk is the difference between the legal reserve and the face amount of insurance

11-*

Exhibit 11.3 Relationship Between the Net Amount at Risk and Legal Reserve (2001 CSO Mortality Table)

11-*

Types of Whole Life Insurance (Continued)

Another characteristic of ordinary life insurance policies is the accumulation of cash surrender values
A policyholder overpays for insurance protection during the early years, resulting in a legal reserve and the accumulation of cash values
The policyholder has the right to borrow the cash value or exercise a cash surrender option
An ordinary life policy is appropriate when lifetime protection is needed and can be used to save money
A major limitation is that some people are still underinsured after the policy is purchased

11-*

Types of Whole Life Insurance (Continued)

Under a limited-payment life insurance policy, the insured has lifetime protection, and premiums are level, but they are paid only for a certain period
The most common limited-payment policies are for 10, 20, 25, or 30 years
A paid-up policy at age 65 or 70 is another form of limited-payment life insurance
A policy is paid up when no additional premium payments are required; it matures when the face amount is paid as a death claim or endowment

11-*

Types of Whole Life Insurance (Continued)

A single-premium whole life policy provides lifetime protection with a single premium
Endowment insurance pays the face amount of insurance if the insured dies within a specified period. If the insured is still alive at the end of the period, the face amount is paid to the policyholder
Endowment insurance accounts for less than one percent of the life insurance in force

11-*

Variations of Whole Life Insurance

Variable life insurance is a fixed-premium policy in which the death benefit and cash values vary according to the investment experience of a separate account, which is similar to a mutual fund maintained by the insurer
The premium is level
The entire reserve is held in a separate account and is invested in common stocks or other investments
Cash-surrender values are not guaranteed and there are no minimum guaranteed cash values

11-*

Variations of Whole Life Insurance (Continued)

Universal life insurance is a flexible premium policy that provides lifetime protection
After the first premium, the policyholder decides the amount and frequency of payments
Premiums, less explicit expense charges, are credited to a cash-value account, also called an accumulation fund
Policies typically have a monthly deduction for administrative expenses
The policies have considerable flexibility

Transparency Master 1.2

11-*

Variations of Whole Life Insurance (Continued)

In a universal life insurance, the protection and savings components are separated
Most policies have a target premium, but the policyholder is not obligated to pay it
A monthly mortality charge is deducted from the cash-value account for the cost of the insurance protection
Insurers typically deduct 5-10 percent of each premium for expenses
Interest earnings credited to the cash-value account depend on the interest rate

11-*

Variations of Whole Life Insurance (Continued)

There are two forms of universal life insurance:
Option A pays a level death benefit during the early years, and the death benefit increases in later years to meet the corridor test required by the Internal Revenue Code
Option B provides for an increasing death benefit which is equal to a constant net amount at risk plus the accumulated cash value

11-*

Exhibit 11.4 Two forms of Universal Life Insurance Death Benefits

11-*

Exhibit 11.5 $100,000 Universal Life Policy, Level Death Benefit, Male, Nonsmoker, Age 25

11-*

Exhibit 11.5 $100,000 Universal Life Policy, Level Death Benefit, Male, Nonsmoker, Age 25 (Continued)

11-*

Variations of Whole Life Insurance (Continued)

Universal life provides considerable flexibility
Cash withdrawals are permitted
Policies receive favorable tax treatment
Limitations include:
Insurers advertise misleading rates of return
Cash-value and premium-payment projections can be misleading and invalid
Insurers can increase the mortality charge
A policy may lapse because some policyholders do not have a firm commitment to pay premiums

11-*

Variations of Whole Life Insurance (Continued)

Indexed universal life insurance is a variation of universal life insurance with certain key characteristics:
There is a minimum interest rate guarantee
Additional interest may be credited to the policy based on investment gains of a specific stock market index
The amount credited is based on a formula which is usually capped

11-*

Variations of Whole Life Insurance (Continued)

Variable universal life insurance is an important variation of whole life insurance
Most are sold as investments or tax shelters
The policyholder decides how the premiums are invested
The policy does not guarantee a minimum interest rate or minimum cash value
These policies have relatively high expense charges, including front-end loads for sales commissions, back-end surrender charges, and investment management fees
The policyholder bears substantial investment risk

11-*

Variations of Whole Life Insurance (Continued)

Current assumption whole life insurance is a nonparticipating whole life policy in which the cash values are based on the insurer’s current mortality, investment, and expense experience
A nonparticipating policy does not pay dividends
An accumulation account reflects the cash value under the policy
If the policy is surrendered, a surrender charge is deducted from the accumulation account
A guaranteed interest rate and current interest rate are used to determine cash values
A fixed death benefit and maximum premium level at the time of issue are stated in the policy

11-*

Variations of Whole Life Insurance (Continued)

There are two forms of current assumption whole life products:
Low-premium products, with a low initial premium and a redetermination provision that allows the insurer to recalculate the premium after the initial guaranteed period expires
High-premium products, with a provision that allows the policyholder to discontinue paying premiums after a certain time period.

11-*

Exhibit 11.6 Comparison of Individual Life Insurance Policies

11-*

Other Types of Life Insurance

A modified life policy is a whole life policy in which premiums are lower for the first three to five years and higher thereafter
One advantage is that applicants can purchase permanent insurance immediately even though they cannot afford the higher premiums for a regular whole life policy
Preferred risk policies are sold at lower rates to individuals whose mortality experience is expected to be lower than average (e.g., a nonsmoker)

11-*

Other Types of Life Insurance (Continued)

Joint life insurance is a policy written on the lives of two or more people and is payable at the time of death of the first person to die
Second-to-Die life insurance insures two or more lives and pays the death benefit upon the death of the second or last insured
The insurance is usually whole life, but it can be term
This form of life insurance is widely used in estate planning

11-*

Other Types of Life Insurance (Continued)

Savings Bank Life Insurance (SBLI) is a type of life insurance that is sold by savings banks
Industrial life insurance is a type of insurance in which the policies are sold in small amounts and an agent of the company collects the premiums at the insured’s home
Group life insurance provides life insurance on a group of people in a single master contract