Chapter 11. Learning Objectives (part 1 of 3) Describe when a person should and should not have life...
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Transcript of Chapter 11. Learning Objectives (part 1 of 3) Describe when a person should and should not have life...
Learning Objectives (part 1 of 3)
Describe when a person should and should not have life insurance
Describe the basic differences between a term and a cash value policy
Describe the various types of cash value policies
Discuss the appropriateness of borrowing against a whole life policy
Learning Objectives (part 2 of 3)
Describe participating policies, riders, and viatical settlements
Compute the value associated with buying term and investing the difference
Compute how much life insurance a person should have
Discuss whether a survivor should pay off a mortgage
Learning Objectives (part 3 of 3)
Describe the way a life insurance company rates a person
Describe how insurance agents are compensated and how this might influence their recommendations
Discuss when insurance coverage should be reviewed
Who Should Buy Life Insurance Anyone and everyone who has
dependents counting on financial support from the income that the insured would earn.
Dependents might include: Minor children Non working spouse Parents who are being supported
Who Should NOT Buy Life Insurance People with no dependents Examples might include:
DINKs where each could live on their own income
Children Retirees Non working spouses
Policy Owner vs. Insured Policy Owner
Pays the premium Controls the policy (e.g., can change the
beneficiary, cash it in) Insured
Person whose life is covered If not same as policy owner, must give
permission to policy owner for the policy
Term Insurance (1 of 2) Good for a fixed time period only Similar to auto insurance (if have
no claim, then at end of term have nothing more than cancelled checks)
Always the cheapest premium per $1,000 of coverage
Term Insurance (2 of 2) Large variety of term policies
1-year, 5-year, 10- year, 20-year To age 65, to age 90 Decreasing Term (Mortgage
insurance)
Cash Value Policy (1 of 2) May be for the life of the insured A cash value associated with the
policy, so that if policy cancelled, the cash value belongs to the policy owner
Can usually borrow against the cash value
Cash Value Policy (2 of 2) Large variety of cash value policies
Whole life Modified Premium or Graded Limited Pay Single Premium Endowment Variable Life Universal Life Variable Universal Life
Borrowing Against a Cash Value Policy (1 of 2) Policy usually has a stated rate for
policy loans Maximum loan usually up to 95%
of current cash value No fixed repayment schedule Deduct from death benefit if
insured dies with loan outstanding
Borrowing Against a Cash Value Policy (2 of 2) Drawbacks to policy loan
Reduction in death benefit Advantages of policy loan
Potential investment arbitrage Give money to beneficiary now Death benefit need may be lower Enjoy some of money while insured
still alive
Participating Policies Company pays a dividend to the
policy owner Dividends are tax free as
considered rebate of premium Dividends make projecting the true
cost of a policy a best guess effort
Riders An attachment to a standard policy Could be free or might require an
extra premium Common riders include:
Conversion Feature Double Indemnity Disability Waiver Accelerated Death Benefits
Viatical Settlements Policy owner sells an existing policy
to a third party Similar to an accelerated death
benefit Usually substantial discounts to face
value (even if insured terminally ill) May be only way to raise cash while
insured still alive
Buying Term & Investing the Difference (1 of 3) True implementation requires:
Buy same death benefit as with W.L. Note the difference in premiums Each year, invest the difference in
premiums Use the value of the investment to
reduce the death benefit when the term policy comes up for renewal
Buying Term & Investing the Difference (2 of 3) Pros of this strategy
With reasonable rates of return, will have a larger estate at time of death if make all investments on schedule
Even if don’t follow this strategy, then enjoy spending the premium difference while still alive
Buying Term & Investing the Difference (3 of 3) Cons of this strategy
If fail to save premiums, then term premiums become prohibitive later in life
May not be able to renew term Most people don’t actually save
premium differences
How much life insurance should a person have? appropriate size premium
approach human life value approach multiple of earnings approach needs approach
Appropriate Size Premium Determine the maximum premium
a policy owner is willing to pay Buy as much insurance as this
premium will allow Rules of thumb are 5 to 10 percent
of family budget
Human Life Value Starts with estimates of future
wage income of the insured Reduces this by portion spent on
the insured Remainder is discounted The sum of present value is the
human life value
Multiple of Earnings Assumes that the ratio of human
life value to current wage rate is approximately the same for people with similar incomes and ages
Thus, one determines these ratios and constructs a look-up table for the various combinations of age and income
Needs (1 of 3) Most complex of the four approaches Based on what expenses the survivors
would face if the insured were to die Easy to be emotional in deciding what
one wants their survivors to have if they die, thus could lead to an overstatement of insurance needs
Needs (2 of 3) Four parts to calculation
Immediate cash needs at time of death
Financial and legal expenses Outstanding bills “Final expenses”
Project annual income for survivors and subtract estimated annual expenses
Needs (3 of 3) Take the present value of the
differences Sum the present values and
subtract current insurance coverage and other financial resources that are available
Which is the best approach? Appropriate size premium: not
relevant Human life value: Maximum coverage Multiple of Earnings: usable if can’t
use a better approach Needs: Maximum coverage Suggested approach: Lesser of HLV &
Needs (one should never be worth more dead than alive)
Should a survivor pay off a mortgage? Paying off a mortgage is
equivalent to investing the money risk-free at the mortgage rate
Not a good idea if it could be invested at a better (risk-adjusted) rate elsewhere
Not a good idea if have liquidity problems
Setting your premium Starts with life expectancy based on the
actuarial table (same for all companies) Each insurer then applies own
standards to determine the likelihood you will survive. These include: Medical exam Smoking history Hobbies (e.g., skydiving) Profession (e.g., policeman)
How insurance agents are compensated Most of compensation is a large
percentage of the first year’s premium Remainder of compensation is a small
percentage of each year’s premium thereafter
=> Like to sell policies with large premiums, and like to upgrade policies