1 Life Insurance C H A P T E R 12 plan was for Susan to reenter the workforce once both children had reached preschool age or older. Susan Perry is thankful for her life insurance agent. Five years ago, she and her husband James had their first child. Susan quit her job to take care of their firstborn, a handsome boy named Eric. Even though the reduced family income made budgets tight, James s income alone was enough to sustain the family. Two years later, Joshua was born and Susan remained out of the job market. The Perrys Sadly, James was killed in an auto accident on his way home from work. It was only then that Susan fully appreciated the benefit of having purchased a $400,000 life insurance policy. Shortly after their first child was born, their neighbor, an insurance agent, approached Susan and James. The agent convinced them that because he was the sole provider for the family, James needed a sizable insurance policy to replace his income in the event of his death. Although it was difficult to fit the premiums into the family budget, the Perrys were able to manage it. Suddenly James was gone. Susan, a young mother with two small children, was devastated. Fortunately for her and the children, the insurance will be enough to sustain them until well after the children are in school and allow her to seek additional schooling before she reenters the workforce. One of the primary assets of a family is the ability to earn income. While income can be reduced 343
2 344 L I F E I N S U R A N C E or eliminated in the event of a disability, death can be even more catastrophic to a family s financial well-being. Without life insurance, the death of a breadwinner eliminates some or all of the household s employment income forever. Life insurance can provide financial protection for members of a household. The objectives of this chapter are to: describe the types of life insurance that are available, identify the factors that influence insurance needs, review the factors that affect life insurance premiums, examine the decision of whether to purchase life insurance, and explain the settlement options that are available for beneficiary payments. life insurance Insurance that provides a payment to a specified beneficiary when the policyholder dies. BACKGROUND ON LIFE INSURANCE Life insurance provides a payment to a specified beneficiary when the policyholder dies. Therefore, it allows you to provide financial support to specified beneficiaries in the event of your death. A $100,000 policy means that in the event that you die, the beneficiary named in the policy will receive $100,000. The amount received by the beneficiary is not taxed. Life insurance is provided by life insurance companies, which may be independent firms or subsidiaries of financial conglomerates. Many financial institutions that provide banking and brokerage services also have a subsidiary that provides life insurance. You pay a premium on a periodic (such as quarterly) basis for life insurance. ROLE OF LIFE INSURANCE Before deciding whether to buy life insurance or how much life insurance to buy, you need to consider your financial goals. The most common financial goal related to life insurance is to maintain financial support for your dependents. Life insurance is critical to protect a family s financial situation in the event that a breadwinner dies. Life insurance provides the family with financial support to cover burial expenses or medical expenses not covered by health insurance. Life insurance can also maintain the family s future lifestyle even without the breadwinner s income. In addition, life insurance may help the dependents pay off any accumulated debt. If you are the breadwinner and have others who rely on your income, you should have life insurance. If no one else relies on your income, life insurance may not be necessary. For example, if you and your spouse both work full-time and your spouse could be self-sufficient without your income, life insurance is not as important. If you
3 TYPES OF LIFE INSURANCE 345 are single and are not providing financial support to anyone, life insurance may not be needed. However, many individuals without dependents still want to leave money to their heirs. For example, you may decide that you want to finance your nephew s college education. If you die before your nephew attends college, a life insurance policy can achieve your goal. Alternatively, you may want to provide financial support for your parents. In this case, you can designate your parents as the beneficiaries in a life insurance policy. You can even set up a life insurance policy that designates your favorite charity as the beneficiary. As time passes, rethink your life insurance decisions. Even if you decide not to purchase life insurance now, you may require life insurance in the future. If you already have a life insurance policy, you may need to increase the coverage or add a beneficiary at a future point. ROLE OF LIFE INSURANCE COMPANIES Many insurance companies can provide you with life insurance coverage in exchange for insurance premiums. It is important that the insurance company be financially sound so that it will be capable of providing the benefits in accordance with your policy. Review the ratings assigned to companies by rating services such as A. M. Best, Standard and Poor s, or Moody s, and only purchase life insurance from companies that are rated highly. TYPES OF LIFE INSURANCE While the needs for life insurance are straightforward, there are many options for policies. Term insurance, whole life insurance, and universal life insurance are the most popular types of life insurance. Each type is described in turn. term insurance Life insurance that is provided over a specified time period and does not build a cash value. TERM INSURANCE Term insurance is life insurance provided over a specified time period. It does not build a cash value, meaning that the policy does not serve as an investment. It is intended strictly to provide insurance to a beneficiary in the event of death. If the insured person remains alive over the term, the policy expires at the end of the term and has no value. Consider the case of a single mother with three young children. She plans to provide financial support for her children until they complete their college education. While her income is sufficient to provide that support, she wants back-up support if she dies. She decides to purchase 20-year term insurance. If she dies during this period, her children will receive the coverage specified in the policy. If she is still living at the end of the term, the policy will expire. Even under these conditions, the policy would have served its purpose, giving her peace of mind over the period by ensuring sufficient financial support for her children. Once the term expires, the children will be old enough to support themselves financially.
4 346 L I F E I N S U R A N C E Term Insurance Premiums. The premium on term insurance is dependent on the likelihood of death over the specified term. This likelihood is affected by your health, age, gender, and the length of the term in which insurance is desired. To illustrate, review the annual premiums at various ages quoted in Exhibit 12.1 by one insurance company for a male nonsmoker who is in excellent health and desires a 10-year term insurance policy. A term insurance premium for a given person will vary among life insurance companies. The focus here on only one life insurance company is useful for recognizing how other factors affect the term insurance premium. Each row in Exhibit 12.1 represents a specific age level. Each column specifies a different amount of insurance coverage. Compare the quotes among the rows in the $500,000 column. For a given level of coverage, the premium is higher for older policyholders. The increase in premiums with advancing age is especially pronounced after age 45. Term insurance is cheaper for younger individuals, because they tend to live longer. Next, compare the quotes among the columns for a given row. For a given age level, the insurance premiums are higher for more coverage. The increase in premiums with more coverage is especially pronounced for older policyholders. Several other factors that affect term insurance premiums are not illustrated in the exhibit. Female policyholders pay a lower premium than male policyholders of the same age and health status, because they tend to live longer. For example, a 40-year-old female may pay a premium that is 10 to 15 percent less than a 40-year-old male with the same health status. Policyholders with health problems at the time they purchase the term insurance tend to pay higher premiums. Since smoking can cause health problems, smokers pay substantially higher premiums than nonsmokers. For example, a 40-year-old male smoker Exhibit 12.1 Example of Quoted Term Life Insurance Premiums Offered over the Internet Amount of Insurance Desired Age $250,000 $500,000 $1,000, $97 $160 $ , , ,536 3, ,340 2,629 5,222
5 TYPES OF LIFE INSURANCE Financial Planning Online: Buying Term Life Insurance Go to: Click on: Insurance under the Planning heading, then click on Life. This Web site provides: step-by-step instructions on shopping for term life insurance. would likely pay more than twice the premium paid by a 40-year-old male nonsmoker for 10-year term insurance. In addition, a 40-year-old female smoker would likely pay more than twice the premium paid by a 40-year-old female nonsmoker for 10-year term insurance. decreasing-term insurance A form of term insurance in which the benefits that will be paid to the beneficiary are reduced over time and the premium remains constant. mortgage life insurance Life insurance that pays off a mortgage in the event of the policyholder s death. Decreasing-Term Insurance. A common type of term insurance is decreasingterm insurance, in which the insurance benefits to the beneficiary are reduced over time. The premium paid for the insurance remains constant over the term. This type of insurance is popular for families because it provides a relatively high level of insurance in the earlier years when it is most needed. As time passes, a family can accumulate savings, pay off part of a mortgage, and increase their investments, so smaller life insurance benefits are needed. Several forms of decreasing-term insurance are available, with different terms and different degrees to which the insurance benefits decrease over the term. The same factors that affect the premium of term insurance also affect the premium of decreasingterm insurance. Mortgage Life Insurance. Mortgage life insurance pays off a policyholder s mortgage in the event of his death. It is commonly purchased to ensure that a family can afford to continue living in their home even if the breadwinner dies. Mortgage insurance is a special form of decreasing-term insurance. In fact, individuals can achieve the same goal (and possibly save money) by purchasing a term insurance policy that provides benefits large enough to pay off the mortgage.
6 348 L I F E I N S U R A N C E renewability option Allows you to renew your policy for another term once an existing policy expires. conversion option Allows you to convert your term insurance policy into a different type of policy (called a whole life policy) that will be in effect the rest of your life. Term Insurance Options. A term insurance policy offers various options to fit your needs. A renewability option allows you to renew your policy for another term (up to an age limit specified in the policy) once the existing term expires. The premium for the next term will be higher than that for the prevailing term, since you will be older. In addition, the premium charged in the next term can increase to reflect any change in your health. The advantage of the renewability option is that your renewal is guaranteed. Without a renewability option, you may not be able to renew your insurance if your health has deteriorated. Many term insurance policies include the renewability option at no extra charge. Make sure that this option is available in any term insurance policy that you consider. A conversion option allows you to convert your term insurance policy into a different type of policy (called a whole life policy, discussed shortly) that will be in effect the rest of your life. An insurance policy with a conversion option specifies the period in which the conversion can occur. At the time of this conversion, the premium will be increased, but it will then stay constant for the rest of your life. whole life insurance Life insurance that continues to provide insurance as long as premiums are paid; not only provides benefits to the beneficiary but also has a cash value. nonforfeiture clause Allows you receive the savings you accumulated if you terminated your whole life policy. WHOLE LIFE INSURANCE Whole life insurance continues to provide insurance as long as premiums are paid; the policy accumulates savings for the policyholder over time. In this way, it not only provides benefits to a beneficiary if the policyholder dies, but also creates a form of savings that has a cash value. For this reason, whole life insurance is sometimes referred to as cash-value life insurance. The cash value is typically specified on a schedule. Your whole life insurance premium is a fixed amount that is used for two purposes: life insurance and savings. A portion of the premium is to pay for the life insurance provided by the policy, so that the beneficiaries you identify in the policy will be covered if you die. The remainder of the premium is invested for you as a form of savings that builds a cash value over time. Nonforfeiture Clause. A key provision of the whole life policy is the nonforfeiture clause, which allows you to receive the savings you accumulated if you terminate your whole life policy. If the policyholder withdraws the cash value, the amount by which the cash value exceeds the premiums that were paid is subject to taxes. The nonforfeiture clause may also offer the alternative of using the cash value to pay for an insurance policy that has a reduced death benefit. That is, you could exchange your existing policy for one that requires no more payments. In essence, your cash value serves as a one-time payment for a new policy. The death benefit in the new policy would be dependent on the cash value amount of the policy that you exchange. Loan Clause. A whole life insurance policy can serve as a source of liquidity. You can borrow against the cash value that has accumulated at an interest rate
7 TYPES OF LIFE INSURANCE 349 specified in the policy. The loan rate is usually lower than rates offered on personal loans by financial institutions. However, recognize that this type of loan reduces the cash value of your insurance policy. Whole Life Premiums. Many insurance policies allow the premium to be paid on a monthly, quarterly, or annual basis. The premium on whole life insurance is constant for the duration of the policy. In the earlier years, a portion of the premium paid for the insurance reflects the potential payout to a beneficiary someday, and the remainder is invested by the insurance company as a form of savings. The portion of the premium dedicated to savings is high in the earlier years when the policyholder is young because the portion of the premium needed to insure against the possibility of death is relatively low. In the later years, the premium required to insure against possible death is relatively high, as the likelihood of death is greater. Because the insurance premium is constant, it is not sufficient to cover the amount needed to insure against possible death in the later years. Thus, a portion of the policy s cash value is used to supplement the premium paid in these years. limited payment policy Allows you to pay premiums over a specified period but remain insured for life. Forms of Whole Life Insurance. Many alternative forms of whole life insurance are available, so policyholders can structure the premium payments in a manner that fits their needs. One such policy is a limited payment policy that allows you to pay premiums over a specified period but remain insured for life. For example, you could make payments until you retire, but continue to be insured even after retirement. If you are 45 years old and plan to retire at age 65, this means you would request a payment period of 20 years. The insurance premiums are larger than if you were required to pay premiums continuously, but you build a large cash value during the payment period. Once the payment period ends, your savings accumulated within the whole life policy are used to cover your future premiums. Alternatively, a whole life policy can be structured to provide a higher level of death benefits to the beneficiaries in the earlier years of the policy than in later years. For example, it may specify insurance coverage of $300,000 over the next 10 years, and $100,000 of coverage after 10 years. This type of policy may be useful for policyholders who have young children. The coverage is higher in the years when the children are young and unable to take care of themselves. Comparison to Term Insurance. The premium for whole life insurance is higher than the premium for term insurance. The advantage of whole life insurance over term insurance is that it not only provides insurance against possible death, but also accumulates savings over time. However, you can accumulate savings on your own by purchasing term insurance with lower premiums and then investing the difference. The choice of term insurance versus whole life insurance is dependent on your particular needs. If you only have life insurance to insure beneficiaries in the event of your death, term insurance is probably most appropriate.
8 350 L I F E I N S U R A N C E 12.2 Financial Planning Online: Should You Buy Whole Life or Term Insurance? Go to: /cgi-bin/calcs/ins5.cgi/ yahoo_insurance Click on: Life Insurance, then Which is better: term or whole Life? This Web site provides: an opinion on whether you should purchase whole life insurance or term insurance based on the premiums and other information. EXAMPLE Stephanie Spratt has a close relationship with her two young nieces, who come from a broken home. While Stephanie is presently focused on building her own wealth, she hopes that she will have sufficient funds someday to pay for her nieces college education. She is considering purchasing life insurance that would provide benefits of $100,000 and naming her nieces as beneficiaries. She will either invest in a 20-year term life insurance policy for $120 per year or in a whole life policy for $500 per year. The whole life premium is higher, but the policy builds a cash value over time. If she buys a term insurance policy for $120 per year, she could invest the difference on her own. If she invests the money in a manner similar to the whole life policy, she will likely be able to accumulate savings more quickly on her own. A whole life insurance policy generally generates low returns on the cash that is invested because part of the premium is used to cover administrative fees. Stephanie decides to purchase the term life policy. If you live beyond the term stated in a term insurance policy, you would have to pay a higher annual premium when establishing a new term insurance policy. Conversely, the premium for the basic whole life policy remains constant. Nevertheless, term insurance is typically a less expensive way to meet your life insurance needs.
9 TYPES OF LIFE INSURANCE Financial Planning Online: Return on Your Whole Life Insurance Policy Go to: tools/calculators Click on: Life Insurance, then What is my return on a whole life policy? The Web site provides: an estimate of the return that you would earn on your whole life insurance policy, based on information about that policy. universal life insurance Life insurance that provides insurance over a specified term and accumulates savings for the policyholder over this time. variable life insurance Life insurance that provides insurance over a specified term and allows policyholders to invest residual funds, after the premium on the term portion is paid, in various types of investments. UNIVERSAL LIFE INSURANCE Universal life insurance provides insurance over a specified term and accumulates savings for policyholders over this time. It is a combination term insurance and a savings plan. Because it allows policyholders to build savings, it is classified as a cash-value life insurance policy. Universal life insurance allows policyholders to alter their payments over time. It specifies the premium needed to cover the term insurance portion. When policyholders pay more than that amount, the extra amount is invested in savings on which policyholders earn interest. Unlike whole life insurance policies where the insurance company makes the investment decisions, policyholders are given a set of alternative investments that are administered by the insurance company and can decide how the savings plan funds are to be invested. If policyholders skip premium payments, the amount needed to cover the term insurance portion or any administrative expenses will be withdrawn from their savings plan. Variable Life Insurance. One type of universal life insurance called variable life insurance allows policyholders to invest the residual funds, after the premium payment on the term portion is paid, in various types of investments, some of which are similar to mutual funds. Variable life insurance differs from whole life insurance in that it allows policyholders to make their own investment decisions.
10 352 L I F E I N S U R A N C E An advantage of universal life insurance is that it provides policyholders with some flexibility in making their payments and in deciding how the savings should be invested. However, the fees on universal life insurance can be high. You can achieve the same benefits by simply purchasing term insurance and investing other money in the manner you prefer, without incurring the high administrative fees that you pay for universal life insurance. Since variable life policyholders can choose to have their savings plan invested in stocks, their cash value can rise substantially during favorable stock market conditions. In the late 1990s, universal life insurance became very popular, as the stock market performed well. However, in the period stock market conditions were very poor, causing major reductions in the cash values of individual policies. DETERMINING THE AMOUNT OF LIFE INSURANCE NEEDED Once you identify the policy type that best suits your needs, your next decision is the policy amount. You can determine the amount of life insurance you need by applying the income method or the budget method, as explained next. income method A method that determines how much life insurance is needed based on the policyholder s annual income. budget method A method that determines how much life insurance is needed based on the household s future expected expenses. INCOME METHOD The income method is a general formula for determining how much life insurance you should maintain based on your income. This method normally specifies the life insurance amount as a multiple of your annual income, such as 10 times your annual income. For example, if you have an annual income of $40,000, this formula would suggest that you need $400,000 in life insurance. This method is very easy to use. The disadvantage is that it does not consider your age and your household situation (including your annual household expenses). Thus, it does not differentiate between a household that has no children and one with four children, which will likely need more life insurance because its expenses will be higher. BUDGET METHOD An alternative method is the budget method (also referred to as the needs method), which determines your life insurance needs by considering your future budget based on your household s future expected expenses and your current financial situation. This method takes factors such as the following into account: Annual Living Expenses. You should have sufficient insurance so that your family can live comfortably without your income. The family s future expenses will be higher if you have children. Younger children will need financial support for a longer period of time. Special Future Expenses. If you want to ensure a college education for your children, you need adequate life insurance to cover the expected future expenses. Debt. If your family relies on your income to cover debt, you may want to ensure that your life insurance can pay off credit card bills and even a mortgage.
11 DETERMINING THE AMOUNT OF LIFE INSURANCE NEEDED 353 Job Marketability of Spouse. If your spouse has very limited job marketability, you may need more life insurance so that your spouse can receive some specialized training. Value of Existing Savings. If you have a large amount of savings accumulated, your family may possibly draw interest or dividends from these savings to cover a portion of their periodic expenses. The more savings your household has accumulated, the less life insurance you need. EXAMPLE Input Function 20 6 N I? PV PMT 0 FV You wish to purchase a life insurance policy that generates a pre-tax income of at least $30,000 per year for the next 20 years to cover living expenses (excluding the mortgage payment) for your spouse and two children in the event that you die. You have just enough savings to cover burial expenses, and you anticipate no unusual expenses for the household in the future. To determine your insurance needs, you must estimate the amount of insurance today that will cover your household s future living expenses. You can use the time value of money concepts from Chapter 3 to determine the amount of funds today that can provide an annuity equal to $30,000 over each of the next 20 years. First, assume that you expect that your spouse will be able to earn at least 6 percent annually by investing the money received from the life insurance policy. Next, estimate the present value of an annuity (see the Present Value of an Annuity Table in the appendix) that can provide your household with a $30,000 annuity over 20 years if it generates an annual return of 6 percent: Amount of Insurance Needed Annuity Amount PVIFA (i 6%, n 20) $30, $344,100. Based on the following additional information about your household, you then adjust the amount of insurance needed: Other Special Future Expenses. You also want to allocate an extra $50,000 in life insurance to pay for your two children s college expenses. Although college expenses will rise in the future, the money set aside will accumulate interest over time, so it should be sufficient. Job Training. You want to have additional insurance of $20,000 to ensure that your spouse can pay for job training in the event of your death. Debt. You have a $60,000 mortgage and no other loans or credit card debt outstanding. You decide to increase the life insurance amount so that the mortgage can be paid off in the event that you die. Therefore, you specify an extra $60,000 in life insurance. By summing up your preferences, you determine you need a total of $474,100 in life insurance. You round off the number, and obtain quotes for policies with coverage of $475,000 or $500,000.
12 354 L I F E I N S U R A N C E LIFE INSURANCE PREMIUMS Now that you have determined how much life insurance you need, the next step is to determine your premiums to purchase life insurance. FACTORS THAT AFFECT YOUR INSURANCE PREMIUMS The premium you pay for life insurance is dependent on the following factors: Amount of Insurance. The larger the amount that a life insurance company must pay your beneficiary in the event that you die, the higher the premium the company will charge you. Cash Value. A cash value life insurance policy requires a higher premium than a term life policy. As mentioned earlier, whole life and universal life insurance can build a cash value, while term insurance does not. If you terminate a cash-value policy, you receive the cash value. Personal Characteristics. Insurance premiums are higher for individuals who are more likely to die in the near future. Thus, they are higher for older persons than for very young persons. The premium is also higher for individuals who smoke because statistics show that, on average, smokers do not live as long as nonsmokers. The premium is also higher for males than females because males do not live as long as females, on average. USING THE INTERNET TO PRICE TERM INSURANCE Many life insurance companies have Web sites where you can obtain quotes on term insurance. The Internet is a very efficient means of purchasing insurance if you know what you want. Information on life insurance premiums is available on Web sites such as insweb.com, insuremarket.com, and quotesmith.com. Web sites quickly provide a quote based on your age, gender, and other information. You may obtain insurance at a lower price because you do not require personal attention; at the same time, you can avoid sales pressure from an insurance agent. FOCUS ON ETHICS: APPLYING FOR LIFE INSURANCE To apply for life insurance, you fill out a detailed application form with information about your medical history and lifestyle that is used to determine your eligibility and premium. If you suffer from a chronic illness such as diabetes or heart disease or are a smoker, your premium will be higher. You may be tempted to omit some information so that you can pay a lower premium. As
13 SETTLEMENT OPTIONS ON A LIFE INSURANCE POLICY Financial Planning Online: How Much Life Insurance Do You Need? Go to: /main.asp This Web site provides: a recommendation for the amount of life insurance that you should have, based on your financial situation. part of the application process, you will most likely go through a medical exam. Between the exam and information available from the Medical Information Bureau, a clearinghouse of medical information that insurers share, the insurer will most likely uncover any inaccuracies in your application. If your application does slip through with inaccuracies, your insurance benefits could be eliminated. The policy is a legal contract between you and the insurance company, so you must be truthful. It is not worth jeopardizing the peace of mind that life insurance brings by trying to save a relatively small amount on premiums. settlement options The alternative ways a beneficiary can receive life insurance benefits in the event that the insured person dies. lump-sum settlement A single payment of all the benefits owed to a beneficiary under a life insurance policy. SETTLEMENT OPTIONS ON A LIFE INSURANCE POLICY Settlement options are the alternative ways a beneficiary can receive life insurance benefits in the event that the insured person dies. Normally, the benefits are not taxed, although there are some exceptions beyond the scope of this text. When you purchase a life insurance policy, you select the settlement option that is most appropriate for your beneficiary. The appropriate option is dependent on the needs and other characteristics of the beneficiaries. Some of the common options are identified next. LUMP SUM A lump-sum settlement provides all the benefits to the beneficiary in a single payment upon the death of the insured. A $250,000 life insurance policy would provide $250,000 to the beneficiary in a lump sum. This settlement is often used
14 356 L I F E I N S U R A N C E if the beneficiary is disciplined and will use the proceeds wisely. If the beneficiary does not have sufficient discipline, however, an alternative settlement option may be more appropriate. installment payments settlement The payment of the benefits owed to a beneficiary under a life insurance policy as a stream of equal payments over a specified number of years. interest payments settlement A method of paying the benefits owed under a life insurance policy in which the company retains the amount owed for a specified number of years and pays interest to the beneficiary. INSTALLMENT PAYMENTS The policyholder can elect to use an installment payments settlement, which means that the beneficiary will receive a stream of equal payments over a specified number of years. For example, instead of paying $300,000 to the beneficiary in a lump sum, the policy may specify that the beneficiary will receive annual payments starting at the time of the policyholder s death and lasting for 10 years. By spreading the amount over time, this settlement option ensures that the beneficiary will not immediately spend the total amount to be received. INTEREST PAYMENTS The policyholder can also elect to use an interest payments settlement, which means that the amount owed to the beneficiary will be held by the life insurance company for a specified number of years. Until the amount is distributed, the beneficiary will receive periodic interest payments on the amount. Like the installment payments option, this settlement option prevents the beneficiary from quickly spending all of the policy proceeds. HOW LIFE INSURANCE FITS WITHIN YOUR FINANCIAL PLAN The following are the key decisions about life insurance that should be included within your financial plan: 1. Do you need life insurance? 2. What type of life insurance is most appropriate for you? 3. How much life insurance should you plan for in the future? Exhibit 12.2 provides an example of how life insurance decisions apply to Stephanie Spratt s financial plan. Exhibit 12.2 How Life Insurance Fits within Stephanie Spratt s Financial Plan Goals for Life Insurance Planning 1. Determine whether I need to purchase life insurance. 2. Determine whether I should purchase or add to my life insurance in the future. Analysis Type of Insurance Plan Benefits Status Term insurance Insurance benefits provided Not needed at this time, since I to beneficiary. do not have a spouse or dependents.
15 SUMMARY 357 Whole life insurance Insurance benefits provided Not needed at this time. to beneficiary, and policy builds a cash value over time. Universal life insurance Insurance benefits provided to Not needed at this time. beneficiary, and policy builds a cash value over time. Decisions Decision on Whether I Need Life Insurance: I decided to purchase term life insurance to provide my two nieces with a college education if I die. My reason for buying life insurance is simply to have insurance, not to build a cash value. Term insurance serves my purpose and is much cheaper than whole or universal policies. Decision on Insurance Coverage in the Future: In the future, I will need to ensure proper life insurance coverage if I have a family. I would want to ensure that my children have sufficient funds to support them and possibly even pay for their college education if I die. If I have a child, I will obtain a 20-year term life insurance policy for $300,000. DISCUSSION QUESTIONS 1. How would Stephanie s decisions regarding purchasing life insurance be different if she were a single mother of two children? 2. How would Stephanie s decisions regarding purchasing life insurance be affected if she were 35 years old? If she were 50 years old? SUMMARY Life insurance provides payments to a specified beneficiary if the policyholder dies. Term insurance is strictly intended to provide insurance in the event of the possible death of the policyholder, while whole life insurance and universal life insurance use a portion of the premium to build a cash value. The premiums for whole life and universal life insurance are higher to account for the portion distributed into a savings plan and for the administrative fees. The amount of life insurance that you need can be measured by the income method, in which you attempt to replace the income that would be discontinued due to death. The amount of life insurance can be more precisely measured by the budget method, which considers factors such as the household s future annual living expenses and existing debt. The life insurance premium is dependent on the amount of life insurance coverage, on whether the life insurance policy has a cash value, and on personal characteristics such as age. The decision to purchase life insurance is partially dependent on whether family members are currently relying on your income. If you decide to purchase insurance, a related decision is the choice of the insurance company. Since the payment from the insurance company to your beneficiaries may not occur until the distant future, you should select an insurance company that you believe will definitely be in service at that time. You can review life insur-
16 358 L I F E I N S U R A N C E ance company ratings to assess their financial condition, which may indicate whether they will survive over time. A life insurance policy can be set up to pay the beneficiary a lump-sum payment, installment payments over a specified period, or interest payments over a specified period with a lump sum at the end of the period. The installment option or interest payment option may be most appropriate for ensuring that beneficiaries do not squander the entire life insurance coverage. INTEGRATING THE KEY CONCEPTS Your decisions regarding life insurance affect other parts of your financial plan. Because life insurance provides income to your beneficiaries in the event of your death, you are not forced to create a level of wealth that will support your dependents. Instead, you can make investment and borrowing decisions without focusing on the future support of your dependents. This allows you to use a more conservative and long-term approach for your investing and borrowing decisions. You may maintain a larger amount of liquidity (Part 2) because there is no pressure to achieve the very highest returns on your money. You can finance a car or a home if you wish (Part 3) because you can more easily afford to make periodic loan payments. You can make more investments in stocks and other securities (Part 5) because you do not have to accumulate a large amount of investments to insure yourself. Finally, you can contribute extra savings to retirement (Part 6). 6. Retirement and Estate Planning (Retirement Planning, Estate Planning) 5. Investing (Stocks, Bonds, Mutual Funds) 1. Financial Planning Tools (Budgeting, Time Value, Tax Planning) Decisions Regarding Life Insurance 4. Protecting Your Assets and Income (Insurance) 2. Liquidity Management (Banking, Money Management, Credit Management) 3. Financing (Personal Loans, Mortgages) REVIEW QUESTIONS 1. What is the purpose of life insurance? Do you think everyone needs life insurance? Explain. 2. What is term insurance? What factors determine the premium for term insurance? What is decreasing-term insurance? 3. What is mortgage life insurance? Is mortgage life insurance a good buy? Why or why not? 4. Briefly describe some of the term insurance options. 5. What is whole life insurance? What benefit does it provide that term life insurance does not? 6. Describe the nonforfeiture and loan clauses of whole life insurance policies. 7. Why is the premium paid for whole life higher than the premium for term life? What alternative approach to purchasing life insurance might provide the same benefits as whole life? 8. What is universal life insurance? How does it differ from term life and whole life? 9. What is variable life insurance? What are the advantages and disadvantages of variable life policies? How can individuals avoid the high fees of variable life insurance?
17 FINANCIAL PLANNING ONLINE EXERCISES Describe the income method of determining the amount of life insurance needed. What is the disadvantage of this method? 11. Describe the budget method of determining the amount of life insurance needed. What elements must be considered in making this calculation? 12. List and briefly discuss the factors that affect an individual s life insurance premium. 13. Explain how the Internet can expedite the purchase of life insurance. Why do many customers prefer this method? 14. What are settlement options? Which option should you choose? 15. What is a lump-sum settlement? What kind of beneficiary would benefit the most from this option? 16. What is an installment payments settlement? When would an insured individual choose this option? 17. What is the interest payments option? How does it differ from the installment payments option? FINANCIAL PLANNING PROBLEMS 1. Nancy is a widow with two teenage children. Nancy s gross income is $3,000 per month, and taxes take about 30 percent of her income. Using the income method, Nancy calculates she will need to purchase about eight times her disposable income in life insurance to meet her needs. How much insurance should Nancy purchase? 2. Nancy s employer provides her with two times her annual gross salary in life insurance. How much additional insurance should Nancy purchase based on the information in the previous problem? 3. Peter is married and has two children. He wants to be sure that he has sufficient life insurance to take care of his family if he dies. Peter s wife is a homemaker but attends college part-time pursuing a law degree. It will cost approximately $40,000 for her to finish her education. Since the children are teenagers, Peter feels he will only need to provide the family with income for the next 10 years. He further calculates that the household expenses run approximately $35,000 per year. The balance on the home mortgage is $30,000. Peter set up a college fund for his children when they were babies, and it currently contains sufficient funds for them to attend college. Assuming that Peter s wife can invest the insurance proceeds at 8 percent, calculate the amount of insurance Peter needs to purchase. 4. Marty and Mary both have jobs and contribute to the household expenses according to their income. Marty contributes 75 percent of the expenses and Mary contributes 25 percent. Currently, their household expenses are $30,000 annually. Marty and Mary have three children. The youngest child is 12, so they would like to ensure that they could maintain their current standard of living for at least the next eight years. They feel that the insurance proceeds could be invested at 6 percent. In addition to covering the annual expenses, they would like to make sure that each of their children has $25,000 available for college. If Marty were to die, Mary would go back to school part-time to upgrade her training as a nurse. This would cost $20,000. They have a mortgage on their home with a balance of $55,000. How much life insurance should they purchase for Marty? 5. Considering the information in the previous problem, how much life insurance should they carry on Mary? 6. Bernd is a college student who has just taken a course in personal financial planning. Since Bernd s plan is to get a job immediately after finishing college, he determines that he will need about $250,000 in life insurance to provide for his future wife (Bernd is not married yet) and future children (Bernd does not have any children yet). Bernd has obtained a quote over the Internet that would require him to pay $200 annually in life insurance premiums. As a college student, this is a significant expense for Bernd, and he would likely have to borrow the money necessary to pay for the insurance premiums. Advise Bernd on the timing of his life insurance. FINANCIAL PLANNING ONLINE EXERCISES 1. Go to INS5.cgi/yahoo_insurance. a. Click on: Which is better: term or whole life? View the findings based on the default information. Click on Graphs to see a graphical presentation of the results. By clicking on the Explanation tab, you will get additional information on the calculations.
18 360 L I F E I N S U R A N C E b. Now change the policy amount to $500,000 for term and $250,000 for whole life. Change the premium to $500 in each case. Keeping other values the same, check the Results, Graph, and Explanation. 2. Go to n_life/main.asp. The Life Insurance Needs Estimator walks you through a series of steps to determine your insurance requirements. After you input amounts in each step, the Estimator will provide you with the results. 3. Go to life/life_calc_index.asp. a. Answer the questions based on your personal information to obtain a life insurance quote. b. Now reduce your estimated monthly after-tax income by 10 percent. How does this change affect the life insurance quote? c. Now reduce your estimated monthly expenses by 10 percent. How does this change affect your life insurance quote? 4. Go to a. Click on life insurance Calculators. Using your personal information, how much life insurance do you need? To determine some of the required inputs (such as the inflation rate) you will need to research other Web sites. b. What is the return on a universal policy based on your personal information? 5. Go to Click on FAQ. Review the section on choosing a type of insurer and comment on this information. Is it good advice? On the same page, read about buying insurance without an agent. What are the pros and cons? BUILDING YOUR OWN FINANCIAL PLAN Life insurance is the most controversial and hard- toselect form of insurance. It is controversial because no external source requires that you have life insurance in the way that you are required to insure an automobile or home. It is also the one form of insurance for which you, the policyholder, will not be the one to file the claim. Selection is difficult because the insurance industry has numerous policy options. On the one hand, there is term insurance, and on the other, whole life. Using the first template provided for this chapter in the Financial Planning Workbook and on the CD-ROM, apply the budget method to determine the amount of life insurance that you need. Next, consider which type of life insurance plan is most appropriate for your needs. Record your determinations on the second template provided for this chapter. If you have determined that you need life insurance, obtain premiums for the policy type and amount you desire at Click on Products & Services tab. At the Tools & Calculators section on the right side of screen, click on Insurance Tools. Click on Life Insurance Quotes toward the bottom of page. Enter the premiums in the third chapter template. Revise your personal cash flow statement as needed to reflect your life insurance decisions. Insurance needs should be reviewed when major changes occur in your life. Specifically, this review should be done if you marry, divorce, or become a parent. THE SAMPSONS A CONTINUING CASE The Sampsons have one remaining insurance need: life insurance. They have decided to purchase term life insurance. They want a life insurance policy that will provide for the family in the event of Dave s death, since he is the breadwinner. The Sampsons do not know how much insurance to purchase, but their goal is to have enough money for general expenses over the next 15 years.
19 IN-TEXT STUDY GUIDE 361 Recall that Dave s salary after taxes is about $40,000. He wants to ensure that the family would have insurance benefits that could provide $40,000 for the next 15 years. By the end of this period, the children would have completed college. Dave also wants to add an additional $300,000 of insurance coverage to provide support for Sharon through her retirement years, since they have not saved much money for retirement. 1. Determine the present value of the insurance benefits that could provide $40,000 over the next 15 years for the Sampson family. Assume that the insurance payment could be invested to earn 6 percent interest over time. 2. Considering the insurance benefits needed to provide $40,000 over the next 15 years, plus the additional $300,000 of insurance coverage, what amount of insurance coverage is needed? 3. Given the total amount of insurance coverage needed and Dave s present age (30 years old), estimate the premium that the Sampsons would pay using one of the insurance Web sites mentioned in the chapter (such as insweb.com). 4. Dave Sampson is a social smoker. Since he only smokes occasionally, he would like to omit this information from the life insurance application. Advise Dave on this course of action. IN-TEXT STUDY GUIDE True/False: 1. Life insurance is intended to provide financial support for your beneficiaries after you die. 2. Whole life insurance provides insurance over a specified term and accumulates savings for policyholders over this time. 3. The loan clause of a whole life policy allows you to receive the savings you accumulated if you terminate your whole life policy. 4. Since the insurance premium in whole life insurance is constant, it is sufficient to cover the amount needed to insure against possible death in the later years. 5. An advantage of whole life insurance over term insurance is that it not only provides insurance against possible death, but also accumulates savings over time. 6. If your spouse has very limited job marketability, you need less life insurance. 7. If you terminate a life insurance policy with a cash value, you forfeit the cash value. 8. Life insurance premiums are higher for older persons than for younger persons. 9. In general, you should purchase life insurance from insurance companies that receive high ratings. 10. Settlement options are the alternative ways in which beneficiaries can pay their premiums. 11. In decreasing-term insurance, the insurance premiums paid by the beneficiary are reduced over time. 12. If the insured person remains alive over the term specified in term insurance, the policy expires at the end of the term and has no value. Multiple Choice: 1. Which of the following institutions are unlikely to offer life insurance policies? a. subsidiaries of financial conglomerates b. independent firms c. financial institutions providing banking and brokerage services d. All of the above may offer life insurance policies. 2. insurance is not a type of life insurance. a. Term b. Wholesale c. Universal life d. Mortgage 3. In insurance, the insurance benefits to the beneficiary are reduced over time. a. decreasing-term b. whole life c. universal life d. mortgage 4. A conversion option of a term insurance policy allows you to convert your term insurance policy into a a. whole life policy. b. mortgage life policy. c. decreasing-term insurance. d. none of the above 5. In decreasing-term insurance, the premiums paid over time. a. increase b. decrease c. remain constant d. none of the above
20 362 L I F E I N S U R A N C E 6. The premium paid for whole life insurance is the premium paid for term insurance. a. higher than b. lower than c. equal to d. none of the above 7. life insurance allows policyholders to alter their payments over time. a. Term b. Whole c. Universal d. Mortgage 8. life insurance pays off a policyholder s mortgage in the event of the person s death. a. Term b. Whole c. Universal d. Mortgage 9. In the method, the life insurance amount is determined as a multiple of your annual income. a. income b. budget c. asset allocation d. none of the above 10. The savings your household has accumulated, the life insurance will be needed. a. more; less b. less; more c. more; more d. Answers (a) and (b) are correct. The following information applies to questions 11 and 12. Otto Klein would like to purchase a life insurance policy that generates an income of at least $40,000 per year for the next 15 years to cover various expenses for his household in the event that he dies. Otto believes that his wife Emma could earn a return of about 7 percent annually. 11. How much insurance does Otto need? a. $14,497. b. $144,978. c. $364,320. d. $82, Now assume that Otto would like to set aside $70,000 to pay off his mortgage in the event that he dies. How much insurance does Otto need? a. $84,497. b. $434,320. c. $389,687. d. $1,001, The premium you pay for life insurance does not depend on which of the following? a. amount of insurance b. cash value c. personal characteristics, such as age d. The premium depends on all of the above. 14. In general, life insurance premiums for males are those for females. a. higher than b. lower than c. the same as d. none of the above 15. The the amount that a life insurance company must pay your beneficiary in the event that you die, the the premium that the company will charge you. a. larger; lower b. smaller; higher c. larger; higher d. Answers (a) and (b) are correct. 16. The premium for a life insurance policy that has a cash value is the premium for a policy that does not have a cash value. a. the same as b. lower than c. higher than d. none of the above 17. You would like to purchase life insurance that will provide your beneficiaries with $20,000 annually for 25 years. You expect your beneficiaries will invest the money at an interest rate of 9 percent. You should purchase in life insurance. a. $231,935. b. $172,461. c. $196,460. d. none of the above 18. Which of the following agencies does not assign ratings to insurance companies? a. A. M. Best b. Standard and Poor s c. Moody s d. Dow Jones Company 19. The settlement option is appropriate only if the beneficiary has sufficient discipline to use the proceeds wisely. a. lump-sum b. installment payments c. interest payments d. none of the above 20. In the settlement option, the beneficiary receives a stream of equal payments over a specified number of years. a. lump-sum b. installment payments c. interest payments d. none of the above
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