Chapter 11Life InsuranceWhy buy life insurance?Premature DeathThe death of a family head with outstanding unfulfilled financial obligationsCostsLost incomeFuneral, uninsured medical, and estate settlement expensesReduction in standard of livingNoneconomic costs (grief, loss of a role model)Premature DeathLife expectancy trends1970 – 70.8 years2010 – 78.7 yearsWho should buy life insurance?Based on:DependentsSpousal roleParentsCorporationsFinancial Impact on Premature DeathSingle PeopleCost of funeral and uninsured medical expensesChild supportSingle – Parent FamiliesVery important to prepare for child’s futureProblem of low incomeTwo – Income Earners with ChildrenReplace economic security of lost incomeReduced dependency on life insuranceTraditional FamiliesImportance of life insurance on each spouseWorking SpouseOther SpouseBlended FamiliesRemarried families with children from each previous marriageWho will care for children?Sandwiched families?Caring for children and dependent parents / family membersDetermining Amount of Life InsuranceThe present value of the family’s share of the deceased breadwinner’s future earningsCalculationEstimate average annual earnings over working lifetimeDeduct taxes and cost of self-maintenanceNumber of years left before retirementDiscount family’s share of earningsHuman Life Value ApproachIt ignores other sources of incomeIt assumes earnings are constantNo changes of employmentIt does not consider changes in allocations of fundsThe discount rate is criticalDetermining Amount of Life InsuranceNeeds approachEstate Clearance FundsImmediate cash to cover needsIncome During Readjustment PeriodGives family time to adjust its living standard to a different levelIncome During Dependency PeriodThe period until the youngest child reaches age 18Life Income to the Surviving SpouseIncome during the Blackout Period (SS)Income to supplement Social SecuritySpecial NeedsMortgage redemption fundEducational fundEmergency fundRetirement NeedsCapital Retention ApproachInsurance proceeds are retained, not liquidatedPrepare a personal balance sheetDetermine amount of income-producing capitalDetermine amount of additional capital neededBequest MotiveTreatment of AssetsIncome earningNon-income earningA number of online calculators exist to assist in calculating the individual’s insurance needsNeed for Life Insurance as of 201044% of households had no individual life insurance30% had no life insurance at allOf those that had any life insuranceAverage of only $154,000 total coverageTypes of Life InsuranceTerm InsuranceTemporary protectionOnly 2% - 3% paid out in death benefitCash – Value InsuranceSavings componentBuilds cash valueTerm InsuranceRenewablePolicy can be renewed without proof of insurabilityConvertibleCan convert to a cash-value policy without evidence of insurabilityNo cash or savings elementTypes of Term InsuranceYearly renewable termIssued for one-year periodRenewablePremiums increase with renewalConvertibleTake it and move to a cash-value policy5-, 10-, 15-, 20-, 25-, or 30-year termPremiums paid during term are levelPremiums increase with renewalTerm to age 65Provides protection up to age 65At age 65, policy expiresCan be converted to permanent policy (must be determined before age 65)Decreasing Term InsuranceFace amount gradually declines each yearReentry TermRenewal premiums based on lower mortality rates if the insured can periodically provide evidence of insurabilityReturn of premium term insurancePremiums are returned at the end of the term periodTerm InsuranceUsesLimitations on spending for insuranceTemporary protectionGuarantee future insurabilityLimitationsPremiums eventually reach prohibitive levelsInappropriate if you wish to save money for a specific needTypes of Life InsuranceWhole LifeCash value policy that provides lifetime protectionCash surrender value – amount paid to the policyholder that surrenders the policyTypes:Ordinary LifeLimited Payment Life10,20,25,30-yrPaid up to 65 or 70Single PremiumOrdinary Life InsuranceLifetime protection to age 121What if the insured lives to the age of 121?The insurance company would pay out the benefit and insured would have to pay taxes on itLevel PremiumsOvercharged during early yearsUndercharged during later yearsCash surrender valueWhole LifeUsesAppropriate when lifetime protection is neededSavings are desiredInsurabilityLimitationsUnderinsured after purchase of policyLow savings rateInflationTypes of Whole Life InsuranceVariable LifeFixed premium policyPolicyholder directs investments and bears risk accordinglyDeath benefit and cash values vary according to underlying investment experienceCash surrender values are not guaranteed, and there are no minimum guaranteed cash valuesUniversal LifeA flexible premium (except first)Target premiumMortality charges and expense chargesInterest RateGuaranteed minimum vs. current rateOption A and Option B (changing net amount at risk)Characteristics of Universal LifeConsiderable flexibilityFrequency and amount of paymentsDeath benefit can be changed (evidence of insurability)Policy loans are permittedCash withdrawals permittedPart or all of cash can be withdrawn (can reduce death benefit)Favorable income-tax treatmentDeath benefit received income tax-freeLimitations of Universal LifeMisleading rates of return (gross, not net)Decline in interest ratesRight to increase the mortality chargeLack a firm commitment to pay premiumsIndexed Universal LifeMinimum guaranteed interest rateAdditional interest based on the gains of a specific stock market indexFormula used to calculate additional interestThere is a cap on the maximum upper limit of additional interestMay also place a limit on the participation rate that appliesMay be lower than 100 percentConfusion and unrealistic performance expectationsVariable Universal LifeAllows the owner to direct investmentsNo guaranteed minimum rate or cash valueHigh expense chargesSubstantial investment riskImportance for minimum paymentsPotential Variable Universal ExpensesFront-end load (sales and commissions) – 5% to 11%Back-end surrender charge – i.e. 5 year level then declineState premium taxes and federal taxes – 3% of premiumInvestment management fees – 0.20% to 1.62%Mortality and Expense charges – 0.60% to 0.90%Administrative costs - $5 to $10 / monthOther Types of Life InsurancePreferred RisksPolicies sold to individuals whose mortality experiences are expected to be lower than averageSecond –
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