Principles of Insurance Exam 2 1 Chapter 11 Life Insurance Premature Death The death of a family head with outstanding unfulfilled financial obligation Can cause serious financial problems for the surviving family members The deceased s future earnings are lost forever Additional expenses are incurred such as funeral expenses Some families will experience a reduction in their standard of living The purchase of life insurance is financially justified if the insured has earned income and others are dependent on those earnings for financial support The need for life insurance varies across family types Single people Single parent families Two income earners with children Traditional families one parent working Blended families remarried with children Sandwiched families also supporting parents Three approaches can be used to estimate the amount of life insurance to own Human life value approach future earnings o Calculated as the present value of the family s share of the deceased breadwinner s o Estimate the individual s average annual earnings over his or her productive lifetime o Deduct taxes insurance premiums and self maintenance costs o Using a reasonable discount rate determine the present value of the family s share of earnings for the number of years until retirement The needs approach amount needed depends on the financial needs that must be met if the family head should die Calculation should consider o An estate clearance fund o Income needed for a 1 2 year readjustment period income level maintained o Income needed for the dependency period until the youngest child reaches 18 o Life income to surviving spouse including income during and after the blackout period o Special needs such as funds for college 2 Capital retention approach preserves the capital needed to provide income to the family Calculation includes o Prepare a personal balance sheet o Determine the amount of income producing capital o Determine the amount of additional capital needed to meet the family needs o Result may well be more insurance than can be afforded Life insurance ownership is limited In 2010 44 percent of households in the U S owned individual life insurance Many families have only a limited amount of discretionary income 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 Families can purchase less costly term insurance Two categories of life insurance Term insurance provides fixed period protection such as for 1 to 30 years Cash value life insurance builds cash surrender values There are many variations of both types available today Term Life Policy protection expires at the end of the policy period unless renewed Most term policies are renewable for additional period Premiums increase at each renewal To minimize adverse selection many insurers have an age limitation beyond which renewal is not allowed such as 70 or 80 Term insurance is appropriate when o Need or prefer to limit current costs o Need for protection is focused on a given period of time o Desire to avoid mixing insurance with savings o The insured wants to guarantee future insurability since most term insurance policies are convertible into cash value policies o Term insurance premiums increase with age at an increasing rate and eventually reach very high levels Whole Life Whole life is a cash surrender value policy that provides lifetime protection State amount is paid to a designated beneficiary when the insured dies regardless of when the death occurs Different types 3 o Ordinary life Level premium policy that provides lifetime protection Premiums are level throughout premium paying period Excess premiums paid during the early years are used to supplement the inadequate premiums paid during the later years of the policy This creates the legal reserve 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 coverage Accumulation of cash surrender values Policyholder overpays for insurance protection during the early years resulting in a legal reserve plus an accumulation of cash Policyowner has the right to borrow the cash surrender value or exercise a cash surrender options Limitations Level premium of whole life increases insurance payments As a result less insurance coverage is achieved near term for the same payment when compared to term insurance For example 500 annually may purchase about 56 000 of ordinary whole life insurance for a 30 year old male But 500 annually would buy 600 000 of five year term insurance o Limited payment life Under limited payment life insurance policy the insured has a 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 30 years Single premium whole life policy provides lifetime protection with a single premium o Variable life Fixed premium policy in which the death benefit and cash surrender values vary according to the investment experience of a separate account maintained by the insurer 4 Premium is level 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 Policyholder bears the risk of any poor investment results o Universal Life After the first premium the policyholder decides the amount and frequency of Flexible premium policy providing lifetime protection payments although a targeted level premium is typically suggested Premiums less expense charges and fees go into a cash value account from which monthly mortality charges for insurance protection are deducted and interest earnings are added Provides cash withdrawals with fees Limitations Insurers may advertise misleading rates of return that exclude fees Cash surrender value and premium payment projections can be misleading and invalid Insurers can increase the mortality charge Policy may lapse because some policyowners do not have a firm commitment to pay premiums Option to skip premium payments can lead to no payments o Indexed universal life Variation of universal life insurance with certain key characteristics There is a minimum