Chapter 13 Life Insurance Policies (Part II) April 18 & 20 Participating vs. Nonparticipating Policies Participating policies pay participating dividends to policy owners who are owners of the company - non taxable since considered return of unneeded premium Participation in expenses, investments, cost of insurance - long term trends Nonparticipating - stock holders participate in the form of stockholder dividends - taxable. 2 1
Basic Types of Life Insurance Coverage Term Life (cheapest form of life insurance) Whole Life Universal Life Variable Life These life policies are different in Death benefit Cash value saving Premium payments Uses 3 Term Life Insurance Purchased for a specific period of time (e.g., 1 or 5 years, or to a specific age, 60-70). If death does not occur during this period, no proceeds are paid. Term insurance may have a face amount that is level or decreasing. On some policies the face amount may increase; this would be a useful feature to handle the reduction of the purchasing power of a fixed face amount due to inflation. Term insurance is used for temporary needs, or when maximum protection is desired for a minimum premium outlay. 4 2
Term Life Insurance Premiums Participating Dividends If Paid x Policy Term If Death Face Paid To Beneficiary 5 Term Life Insurance Renewable feature The risk of becoming uninsurable is transferred to the insurer. Insured pays premium based on attained age and no medical exam is required. Contracts are generally renewable until age 65 or 70. Convertible feature The insured is able to convert to a permanent form of coverage within a specified time period without evidence of insurability. The risk of becoming uninsurable is transferred to the insurer. Re-entry term life insurance Policy owner pays low premium as long as she/he can pass a medical exam periodically (each 5 years). If cannot pass the medical exam, the premiums increase significantly. Refer to the medical selection effect. 6 3
Term Insurance - Uses Temporary needs Funds for premiums limited but life insurance need is great Remember: Does not involve saving Premiums increase with age Usually unavailable after age 70-75 Most term polices do not pay a death claim because of the period being covered. This is why term is relatively inexpensive. Example? 7 Use of Term Life Example Term insurance would be most appropriate for a young husband and wife with children and a mortgage where a lot of insurance is needed to cover dependency years and college costs. 8 4
Consists of: Term Life Premium Cost to pay death claims (MORTALITY COST), plus a risk reserve (?) Expenses and profit for the insurer Investment income 9 Whole Life Policy In exchange for a premium the insurer promises to pay a beneficiary the face amount, whenever death occurs. Whole life insurance involves a savings (cash value) element as the payments in the early years of a policy exceed the mortality cost. These "overpayments" plus a survivor benefit and compound interest on them allow the "underpayments" in later years when the premium is less than the mortality cost. Coverage lasts until death, or age 100. 10 5
Whole Life Insurance $1,000 Policy face Cash value $14/year 25 age Level Premium 100 11 Different Payment Patterns for Whole Life Insurance $1,000 PVFB Whole life paid up at 65 20 pay life 10 pay life Single premium life (MEC) x time 100 12 6
Example For a healthy man aged 27, rank the following policies in the order of their premium size. List the policy with the largest premium first: Continuous-premium whole life Ten-payment whole life Single-premium whole life Whole life paid up at age 65 13 Uses of Whole Life Permanent Needs: Burial Income for permanent dependents - spouse, child, parents Federal Estate Tax (FET) State death taxes Business continuation Estate planning 14 7
Uses of Whole Life Savings function: Many people do not save unless forced to do so Investment management is provided. With participating policies, dividends are increased with improved investment results There are some tax advantages with cash value whole life. Cash values and/or proceeds are protected from creditor's claims. 15 Uses of Whole Life Policy Whole life insurance would be most appropriate for a husband and wife with children and a sizeable estate generated through an owned business. Whole life would be needed to handle the estate tax and probate issues and provide taxdeferred savings. Tax and probate costs occur whenever the insured dies. 16 8
Consists of: Whole Life Premium Same components of a term life insurance premium, PLUS extra money to fund savings The feature of cash value 17 Mechanics of Whole Life If you dies before age 100 Beneficiary receives face value, which is paid out of the mortality cost component in everyone else s (the pool s) premiums. Cash value becomes survivorship benefit to those still alive If you live to be age 100 Cash value = death benefit Insurer pays you the face value 18 9
Mechanics of Whole Life If you decide you do not want death protection, you can withdraw cash value and terminate the policy. If you decide to keep death protection but access savings (cash value), Borrow your cash value If you die before you pay it back (?) Types of Whole Life Policies: Single premium, continuous premium, limited payment. 19 Sources of Flexibility in the Traditional Whole Life Insurance Contract Accelerated Death Benefits Pays a portion of the face amount when an insured is certified terminally ill - expected to die within 12 months Guaranteed Insurability Option Allows the policy owner to purchase additional amounts of insurance at specified dates without evidence of insurability 20 10
Universal Life Insurance ULI death benefits Plan A fixed death benefit versus Plan B variable death benefit. Features of ULI a. Flexibility of premium payments b. Interest rate opportunity (risk shifted to the policy owner) c. Flexibility in death benefits d. Transparency of costs and returns 21 Universal Life -- Plan A $100,000 Death Benefit = Specified Amount Cash value X age 22 11
Universal Life -- Plan B Death Benefit = Specified Amount + Cash Value $100,000 $100,000 Cash Value X age 23 Uses of ULI & VLI Fulfill the buy-term and invest the difference strategy. The amount and timing of premium payments are flexible, the policy is considered a whole life contract, cash value amounts are invested on a tax-deferred basis, and the risk of the investment is shouldered by the insured. These polices are particularly useful where a whole life contract is needed and the person wants to take advantage of the tax-deferred investing, while benefiting from professional investment management while generating market rate of returns. 24 12
Buy Term and Invest the Difference Table 13-7 (p. 269) illustrates the difference in premiums between term insurance and whole life insurance. The BTID strategy is based on the notion that the investment return and accumulated savings outside the life insurance policy may be significantly greater than returns and accumulations inside the policy. 25 Buy Term and Invest the Difference Advocates say: a. Death benefits and savings amount are available at death b. Needs for life insurance do not exist after age 65 c. Earnings outside life insurance can be greater Arguments against: a. Safety, guaranteed earnings, and creditor protection is lost b. Most people cannot save regularly c. Most people are not skilled investors d. Needs can and do continue beyond age 65 26 13
Advantages of Life Insurance The cash value and death benefit of a life insurance policy are fully exempt from creditors and from all demands in any bankruptcy. Death benefit proceeds are exempt from federal income tax but may be subject to estate taxes under certain conditions. Interest and dividends paid on a life insurance policy accumulate tax deferred. Forces people to save cash value policies. Investments are managed by professional portfolio managers. Guaranteed earnings in most policies. 27 Objective Question #1 The most simple form of life insurance is: a. Single premium whole life. b. Term life insurance. c. Universal life insurance. d. Variable life insurance. 28 14
Objective Question #2 Choose the true statement about whole life insurance: a. Builds a guaranteed savings (cash) value. b. Must be purchased in amounts greater than $100,000. c. Is usually the insurance with the lowest premium for a given age. d. Provides temporary protection. 29 Objective Question #3 Each of the following features distinguishes universal life insurance from traditional whole life insurance except: a. Universal life allows consumers to see the component costs and returns. b. Universal life allows flexibility of premium payments. c. Universal life allows borrowing the face amount after the first five years. d. Universal life provides some flexibility in death benefits. 30 15
Objective Question #4 Choose the true statement about variable life insurance: a. Savings values are guaranteed. b. Cost is usually lower than term insurance. c. The policy owner has flexibility in investment choice. d. Investment risk borne by the insurance company. 31 Objective Question #5 The investments supporting the cash values of traditional whole life insurance policies are: a. common stock / equity investments b. short-term government debt issues c. municipal debt d. federal government debt issues and real estate mortgages 32 16
Objective Question #6 Choose the TRUE statement about industrial life insurance. a. It is also called discount life insurance b. It is more expensive than ordinary life insurance c. It is less expensive than ordinary life insurance d. It is widely used in estate plans 33 Objective Question #7 Choose the TRUE statement about convertible term life insurance. a. It is cheaper to convert the older the insured gets. b. It allows conversion from individual to group insurance. c. It allows the insured to convert to whole life insurance within 5 years of a spouse s death. d. It allows conversion from term to cash value life insurance. 34 17
Objective Question #8 Selling which of the following types of life insurance policies requires registering with the NASD? a. Variable life insurance b. Term life insurance c. Whole life insurance d. Limited-pay whole life insurance 35 18