04 21 2014 Chapter 11 Life Insurance Why buy life insurance Premature Death o The death of a family head with outstanding unfulfilled financial obligations Costs o Lost income o Funeral uninsured medical and estate settlement expenses o Reduction in standard of living o Noneconomic costs grief loss of a role model Premature Death Life expectancy trends o 1970 70 8 years o 2010 78 7 years Who should buy life insurance o Based on Dependents Spousal role Parents Corporations Financial Impact on Premature Death Single People o Cost of funeral and uninsured medical expenses o Child support Single Parent Families o Very important to prepare for child s future o Problem of low income Two Income Earners with Children o Replace economic security of lost income o Reduced dependency on life insurance Traditional Families o Importance of life insurance on each spouse Working Spouse Other Spouse Blended Families o Remarried families with children from each previous marriage o Who will care for children Sandwiched families o Caring for children and dependent parents family members Determining Amount of Life Insurance The present value of the family s share of the deceased breadwinner s future earnings Calculation o Estimate average annual earnings over working lifetime o Deduct taxes and cost of self maintenance o Number of years left before retirement o Discount family s share of earnings Human Life Value Approach It ignores other sources of income It assumes earnings are constant o No changes of employment It does not consider changes in allocations of funds The discount rate is critical Determining Amount of Life Insurance Needs approach o Estate Clearance Funds Immediate cash to cover needs o Income During Readjustment Period different level o Income During Dependency Period Gives family time to adjust its living standard to a The period until the youngest child reaches age 18 o Life Income to the Surviving Spouse Income during the Blackout Period SS Income to supplement Social Security o Special Needs Mortgage redemption fund Educational fund Emergency fund o Retirement Needs Capital Retention Approach o Insurance proceeds are retained not liquidated Prepare a personal balance sheet Determine amount of income producing capital Determine amount of additional capital needed o Bequest Motive o Treatment of Assets Income earning Non income earning A number of online calculators exist to assist in calculating the individual s insurance needs Need for Life Insurance as of 2010 o 44 of households had no individual life insurance o 30 had no life insurance at all Of those that had any life insurance o Average of only 154 000 total coverage Types of Life Insurance Term Insurance o Temporary protection o Only 2 3 paid out in death benefit Cash Value Insurance o Savings component o Builds cash value Term Insurance Renewable Convertible o Policy can be renewed without proof of insurability o Can convert to a cash value policy without evidence of insurability No cash or savings element Types of Term Insurance Yearly renewable term o Issued for one year period o Renewable o Premiums increase with renewal o Convertible Take it and move to a cash value policy 5 10 15 20 25 or 30 year term o Premiums paid during term are level o Premiums increase with renewal Term to age 65 o Provides protection up to age 65 o At age 65 policy expires o Can be converted to permanent policy must be determined before age 65 Decreasing Term Insurance o Face amount gradually declines each year Reentry Term o Renewal premiums based on lower mortality rates if the insured can periodically provide evidence of insurability Return of premium term insurance o Premiums are returned at the end of the term period Term Insurance Uses o Limitations on spending for insurance o Temporary protection o Guarantee future insurability Limitations o Premiums eventually reach prohibitive levels o Inappropriate if you wish to save money for a specific need Types of Life Insurance Whole Life o Cash value policy that provides lifetime protection o Cash surrender value amount paid to the policyholder that surrenders the policy o Types Ordinary Life Limited Payment Life 10 20 25 30 yr Paid up to 65 or 70 Single Premium Ordinary Life Insurance Lifetime protection to age 121 What if the insured lives to the age of 121 would have to pay taxes on it Level Premiums o Overcharged during early years o The insurance company would pay out the benefit and insured o Undercharged during later years Cash surrender value Whole Life Uses o Appropriate when lifetime protection is needed o Savings are desired o Insurability Limitations o Underinsured after purchase of policy o Low savings rate o Inflation Types of Whole Life Insurance Variable Life o Fixed premium policy o Policyholder directs investments and bears risk accordingly o Death benefit and cash values vary according to underlying investment experience o Cash surrender values are not guaranteed and there are no minimum guaranteed cash values Universal Life o A flexible premium except first o Target premium o Mortality charges and expense charges o Interest Rate Guaranteed minimum vs current rate o Option A and Option B changing net amount at risk Characteristics of Universal Life Considerable flexibility o Frequency and amount of payments o Death benefit can be changed evidence of insurability o Policy loans are permitted Cash withdrawals permitted o Part or all of cash can be withdrawn can reduce death benefit Favorable income tax treatment o Death benefit received income tax free Limitations of Universal Life Misleading rates of return gross not net Decline in interest rates Right to increase the mortality charge Lack a firm commitment to pay premiums Indexed Universal Life Minimum guaranteed interest rate Additional interest based on the gains of a specific stock market index o Formula used to calculate additional interest There is a cap on the maximum upper limit of additional May also place a limit on the participation rate that interest applies May be lower than 100 percent Confusion and unrealistic performance expectations Variable Universal Life Allows the owner to direct investments No guaranteed minimum rate or cash value High expense charges Substantial investment risk o Importance for minimum payments Potential Variable Universal Expenses Front end load sales and commissions 5 to 11 Back end surrender charge i e 5 year level then decline State premium taxes and federal taxes 3 of premium
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