CH 11 - Life Insurance

Under a term insurance policy, protection is temporary

*Protection expires, at the end of the policy period, unless renewable for additional periods*

An ordinary life policy is appropriate when

*lifetime protection* is needed - The major limitation of ordinary life insurance is that some people are still underinsured after the policy is purchased

Three approaches can be used to estimate the amount of life insurance to own:

- Human life value approach - Needs approach - Capital retention approach

Capital Retention Approach

- Preserves the capital needed to provide income to the family - To calculate, prepare a personal balance sheet - Determine the amount of income‐producing capital - Determine the amount of additional capital needed to meet the family needs

Life insurance policies can be classified in two general categories

- Term insurance - provides temporary protection - Permanent Coverage or cash-value life insurance has a savings component and builds cash values - There are many variations of both types available today

Needs Approach

- The amount needed depends on the financial needs that must be met if the family head should die - Calculation should consider an estate clearance fund, cash needed for burial expenses, uninsured medical bills, and taxes - Income needed for the readjustment period, a 1‐2 year period in which the family adjusts to its new living standard - Income needed for the dependency period until the youngest child reaches age 18 - Life income to the surviving spouse, including income during and after the blackout period. - Special needs, e.g., funds for college education and emergencies - Retirement needs

Human Life Value Approach

- The amount needed depends on the insured's human life value, which is the present value of the family's share of the deceased breadwinner's future earnings - To calculate, estimate the individuals average annual earnings over his or her productive lifetime - Deduct taxes, insurance premiums, and self-maintenance costs - Using a reasonable discount rate, determine the present value of the family's share of earnings for the number of years until retirement

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 insured performs services for the family that would need to be replaced upon the insured's death (e.g. childcare, cooking, family logistics) - Resulting expenses are incurred; e.g., funeral

Term insurance is appropriate when

- the amount of income that can be spent on life insurance is limited - the need for protection is temporary - the insured wants to guarantee future insurability HOWEVER - Term insurance premiums increase with age at an increasing rate and eventually reach prohibitive levels - Term insurance is inappropriate if you wish to save money for a specific need

Most term policies are *renewable* for additional periods

-* Premiums increase at each renewal* - To minimize adverse selection, many insurers have an age limitation beyond which renewal is not allowed

Whole life insurance

a cash value policy that provides lifetime protection - A stated amount is paid to a designated beneficiary when the insured dies, regardless of when the death occurs

Variable life insurance

a fixed‐premium policy in which the death benefit and cash values vary according to the investment experience of a separate account maintained by the insurer - The premium is level - The entire reserve is held in a separate account and is invested in common stocks or other investments - Cash surrender values are not guaranteed - *Primary distinguishing feature: its investment options*

Universal life insurance

a flexible premium policy that provides lifetime protection -After the first premium, the policyholder decides the amount and frequency of payments - Most policies have a target premium, but the policyowner is not obligated to pay it - primary distinguishing feature: its premium payment flexibility

Ordinary life insurance

a level‐premium policy that provides lifetime protection - premiums are level throughout the premium-paying period - The excess premiums paid during the early years are used to supplement the inadequate premiums paid during the later years of the policy. - 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

Industrial life insurance

a type of life insurance in which the policies are sold in small amounts and an agent of the company collected the premiums at the insured's home (not as common now)

Variable universal life insurance

an important variation of whole life insurance - most are sold as investments or tax shelters - The policyowner decides how the premiums are to be invested - The policy does not guarantee a minimum interest rate or minimum cash value - These policies have *relatively high expense charges*, including front‐end loads for sales commissions, back‐end surrender charges, and investment management fees

Another characteristic of ordinary life insurance policies is the accumulation of

cash surrender values - A policyholder overpays for insurance protection during the early years, resulting in a legal reserve and the accumulation of cash values - The policy owner has the right to borrow the cash value or exercise a cash surrender option

Yearly-Renewable term insurance

issued for a one‐year period

Credit life

pays off a loan if the borrower dies; the bank or lending institution is the beneficiary

Group life insurance

provides life insurance on a group of people in a single master contract

single premium whole life policy

provides lifetime protection with a single premium *very very expensive

Term to age 65 policy

provides protection to age 65, at which time the policy expires

Premature Death

the death of a family head with outstanding unfulfilled financial obligations - the deceased's future earnings are lost forever - additional expenses incurred; e.g., funeral expenses, uninsured medical bills, and estate settlement costs - Some families will experience a reduction in their standard of living - noneconomic costs are incurred, e.g., grief

Decreasing term insurance

the face value gradually declines each year *good for mortgage protection

limited-payment life insurance policy

the insured has 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, or 30 years or to age 65 or 70

Most term policies are *convertible*

the policy can be exchanged for a cash‐value policy without evidence of insurability - Under the *attained-age method*, the premium charged for the new policy is based on the insured's attained age at the time of conversion - *original-age method*: the premium charged for the new policy is based on the insured's original age when the term insurance was first purchased