Chapter 8 Introduction to Financial Underwriting

Main benefits of life insurance for policy owners + insureds

-the cash value in some life insurance policies can be borrowed against in the event of a financial crisis -policy premiums can be paid in ways that reduce the -income tax burden on the policy payor the death benefit payable to the policy beneficiaries.

Death benefit of multiple of earnings is used to:

1. Hire a replacement. The unexpected death of a key person can cause a company to offer a salary somewhat higher than normal to get a qualified replacement quickly. 2. Offset the cost of training the replacement employee. Depending on the position, this amount can be considerable. 3. Compensate the company for the financial losses created by the key person's death.

Three important questions regarding charitable gifting:

1. Is this a legitimate charity? 2. What is the relationship between the insured and the charity? 3. How much is an appropriate amount?

Four main factors to compute Human Life Value

1. actual after-tax earnings 2. projected rate of earnings growth 3. expected length of career 4. discount rate for future earnings.

7 Factors to consider of Key Employee

1. age of the proposed insured 2. proposed insured's level of expertise 3. business history of the proposed insured 4. stability of earnings over time 5. number of key employees 6. business history of the company 7. current financial picture

Advantages of multiple of salary method

1. easy to use 2. useful in simple sales situations.

These lump sum and income requirements produce a death benefit with the following characteristics:

1. provides a somewhat larger benefit in the period immediately following the death of the insured to offset additional expenses 2. satisfies the normal living expenses of surviving dependents 3. provides a long-term income for the retired surviving spouse and/or disabled family member(s), if any.

Four things buy sell agreements provide:

1. providing an immediate market for the business interest 2. providing liquid funds for use by the estate 3. allowing for the continuance of the business Chapter 8 - Page 14 4. making the business more creditworthy to lenders, who value the continuity of the business.

Disadvantages of the multiple of income method are that it does not account for:

1. the age of the surviving spouse 2. the existence of another family wage earner 3. the number of dependents 4. the number of years for which income may be needed 5. any changes in government benefits 6. monetary inflation 7. income growth.

9. In the United States, the limit that differentiates larger, taxable estates from smaller non- taxable estates is: 1. the exclusion amount 2. income tax 3. Tax Hike Prevention Act of 2010 4. capital gain

1. the exclusion amount

What are examples of insurable value?

1. to replace income that will be lost to his family 2. to pay funeral expenses 3. to pay for his children's education and any special needs they have 4. to pay off any debts he owes at the time of his death 5. to pay the estate taxes due at his death 6. to make a charitable bequest 7. to provide funds that allow his business partner to continue running the company 8. to provide funds for the company to purchase his business interests from his heirs.

Financial statements include:

1. total income received 2. expenses paid out 3. net income or profits (total income minus expenses equals net income or profits) 4. assets owned 5. liabilities or debts owed 6. net worth (assets minus liabilities equals net worth).

Important things to consider with creditor insurance:

1. understanding of the purpose of the loan 2. verifying the legitimacy of the lender 3. assessing the chances of success of the business purpose that the loan is funding 4. reviewing the business finances as well as the underlying assets that guarantee the loan to the lender.

Examples of insurable interest relationships:

1.the relationship between young children and their parents 2.the relationship between a non-working spouse and the family breadwinner 3.a situation involving business owners who badly need the skills of their top salesperson tokeep the company profitable.

1. In Canada, life insurance can be purchased to offset which tax: 1. property 2. estate 3. capital gains 4. sales

3. capital gains

10. The human life value method takes into account all of the following EXCEPT: 1. actual after-tax earnings 2. projected rate of earnings growth 3. the potential for unemployment 4. discount rate for future earnings

3. the potential for unemployment

3. Which of the following statements regarding deferred compensation plans is/are correct? A. They are in addition to the basic benefits available to all employees. B. They allow executives to accrue extra funds for retirement. C. They are usually permanent insurance plans with large internal values. Answer Options: 1. A only is correct 2. B only is correct. 3. B and C only are correct. 4. A, B, and C are correct.

4. A, B, and C are correct.

7. Methods of calculating income replacement for personal life insurance include which of the following? A. multiple of salary B. human life value C. needs analysis Answer Options: 1. A and B only are correct 2. A and C only are correct. 3. B and C only are correct. 4. A, B, and C are correct.

4. A, B, and C are correct.

8. Typical examples of insurable interest with regard to financial dependence include which of the following? A. the relationship between young children and their parents B. the relationship between a non-working spouse and the family breadwinner C. a situation involving business owners who require the skills of a top salesperson to keep the company profitable Answer Options: 1. A and B only are correct 2. A and C only are correct. 3. B and C only are correct. 4. A, B, and C are correct.

4. A, B, and C are correct.

6. The type of business insurance that indemnifies a company against the loss of an employee whose skills are critical to the firm is: 1. creditor 2. cross-purchase 3. income replacement 4. key person

4. key person

2. In the United States, life insurance is used in the estate planning process for all of the following reasons EXCEPT to: 1. offset probate costs 2. provide cash for use by the estate 3. pay estate taxes 4. replace key person income

4. replace key person income

Methods of calculating income replacement for personal life insurance include which of the following? A. Multiple of salary B. Human life value C. Business loss approach A only are correct A and B are correct B and C only are correct A, B, and C are all correct

A and B are correct

The Human Life Value method of computing income replacement insurance takes into account which of the following factors? A. Actual after-tax earnings B. Expected length of career C. Discount rate for past earnings A only is correct A and B are correct A and C are correct A, B and C are all correct

A and B are correct

Which of the following is/are steps in underwriting creditor insurance? A. Understanding the purpose of the loan B. Verifying the legitimacy of the lendee C. Reviewing business finances and underlying assets that guarantee the loan A only is correct A and C are correct B and C are correct A, B and C are all correct

A and C are correct

business history of the company -

A company with a successful business history is often supported by a cadre of competent managers and technical workers who qualify as key employees. On the other hand, it is inadvisable to insure the value of an employee whose contribution to a marginal or failing business is questionable.

All of the following statements regarding the use of life insurance for charitable gifting are correct EXCEPT: The charity must be legitimate. A multiple of annual income is used to determine face amount. The relationship between the insured and the charity must be established. A Section 501(c)(3) charity is considered a legitimate charitable institution.

A multiple of annual income is used to determine face amount.

Contestable Clause

A provision in an insurance policy setting forth the conditions under which, or the period of time during which, the insurer may contest or void the policy. After that time has lapsed, normally 2 years, the policy cannot be contested.

When underwriting Key Person coverage, which of the following should be considered? A. Age of the proposed insured B. Number of Key Employees C. The proposed insured's level of expertise B only is correct A and B are correct B and C are correct A, B and C are all correct

A, B and C are all correct

Which of the following are examples of insurable interest with regard to financial dependence? A. The relationship between young children and their parents B. The relationship between a non-working spouse and the family breadwinner C. A situation involving business owners who require the skills of a top salesperson to keep the company profitable A and B only are correct A and C only are correct B and C only are correct A, B and C are correct

A, B and C are correct

business history of the proposed insured -

An employee or business owner with a record of success, promotion, and achievement can readily qualify as a candidate for key person insurance. On the other hand, underwriters should be cautious if individuals have a history of business failure or bankruptcy or if they have little or no past experience in the career for which they are trying to qualify for key person coverage.

age of the proposed insured -

An older employee soon to retire may not qualify for much, if any, key person insurance.

Which of the following statements regarding deferred compensation plans is/are correct? A. They are available to all employees. B. They allow executives to accrue extra funds for retirement. C. Their administrative cost is assumed by the company. A only is correct A and B are correct B and C only are correct A, B and C are all correct

B and C only are correct

How do you base the cost for the non-working spouse?

Based on the cost of replacing the services of the non-working spouse with outside vendors OR surviving spouse will stop working temporarily and assume all the responsibilities of the deceased spouse.

Business Insurance

Business insurance covers the financial relationships that exist between business owners, employees, debtors, and creditors.

Buy Sell agreement

Buy-sell agreements use either a fixed value for the business or a formula. Buy-sell agreements are important documents when reviewing large or complex buy-sell cases.

The difference between an asset's purchase price and selling price, when the selling price is greater is called: Estate Taxes Capital Gains Exclusion Amount Gifting

Capital Gains

stability of earnings over time -

Companies with a history of stable business earnings make the calculation of a key person's value easier than those with an unstable history of business earnings. A very unstable pattern may not qualify the key person for any coverage.

Estate Planning

Cover federal and state estate taxes Provides cash needed to avoid liquidating closely held companies or illiquid assets Preserves the estate so it can be passed to heirs

Two Types of Buy-Sell Agreements

Cross Purchase Agreements Liquidation/Stock Redemption agreements

In Canada: there are no, but ....

Estate taxes, but the assets are subject to capital gains tax

Before the____, _____ was non existent

Great Depression in the 1930s, financial underwriting

proposed insured's level of expertise -

Higher levels of management or technical expertise or unique and special skills qualify a proposed insured more easily for key person insurance. A low level or entry-level employee doing unspecialized work probably will not qualify for any key person insurance.

Sources of Financial Date

Insurance Application Cover Letter Financial statements Buy Sell agreements Inspection report

5. Describe sources of financial data an underwriter can request or receive to evaluate the amount of insurance being purchased.

Insurance Application: a description of the insured's occupation and age, the policy beneficiary, and basic financial data Cover Letter: assist in validating the sale and explaining the relevant details of the case. Financial Statements: review of personal and business financial statements, the income statement and balance sheet Buy-sell agreements: to find out the methodology behind the valuation of the company. Inspection report: an important check on financial information contained elsewhere in the application or financial statements.

All of the following are a method in calculating income replacement life insurance coverage EXCEPT: Multiple of Debt Method Human Life Value Method Multiple of Salary Method Needs Analysis Method

Multiple of Debt Method

4. Explain three methods of calculating the amount of life insurance needed when considering income replacement and explain the advantages and disadvantages of each method.

Multiple of Income Method: maximum death benefit is a multiple of the insured's income, it is simple but may not be very accurate because it does not adjust to reflect individual circumstances. Human Life Value: a measurement of the earnings potential of the insured's life, it is more sophisticated but relies on an estimate of the future inflation rate and expected increases in income. If these estimates are inaccurate, the insurance need could be underestimated or overestimated. Needs Analysis: identifies the specific lump sum and income needs of the beneficiaries and translates them into a proposed death benefit, it can be comprehensive in its scope but in complex financial planning situations can require an exhaustive amount of research and computation. Also, the needs analysis approach ignores family earnings and can produce an insurance amount based purely on need, not income, creating a situation where the insured is worth much more dead than alive.

Three methods of Income Replacement Insurance

Multiple of Salary Human Life Value Method Need Analysis

Multiple of earnings:

Multiply annual earnings by an arbitrary number, rule of thumb 5 to 10 times annual take-home pay

What is insurable interest?

Policy owners and beneficiaries have a substantial financial interest in the continued life of the insured and would suffer a significant financial loss in the event of his or her death.

current financial picture -

Regardless of the business history or stability of earnings, the current financial picture of the company should be favorable in order to justify key person coverage on business owners, managers, and technical workers.

The rule or law that prevents beneficiaries and their heirs or representatives from profiting from murder is: Common Law Suicide Clause Slayer's Rule Incontestable clause

Slayer's Rule

4 main ways to protect against fraudulent claims:

Slayers rule Slayers statute Suicide clause Contestable clause

number of key employees -

The fewer the number of key employees, the more critical each one is.

Strength and Weakness of Human Life Value:

The human life value approach is more sophisticated but relies on an estimate of the future inflation rate and expected increases in income. If these estimates are inaccurate, the insurance need could be underestimated or overestimated.

Strength and Weakness of Multiple of Income:

The multiple of income method is simple but may not be very accurate because it does not adjust to reflect individual circumstances.

Strength and Weakness of Needs Analysis:

The needs analysis approach can be comprehensive in its scope but in complex financial planning situations can require an exhaustive amount of research and computation. Also, the needs analysis approach ignores family earnings and can produce an insurance amount based purely on need, not income, creating a situation where the insured is worth much more dead than alive.

Deferred compensation and executive bonus plans

These policies are usually permanent plans with large internal values that allow executives to accrue extra funds for retirement while at the same time providing a valuable insurance benefit. They accumulate tax free

Insuring a Child

Usually low insurable value using anticipation of insurance need as adults Typically associated with cash value products Can use large death benefits to justify for estate planning reasons

What is insurable value?

a calculation of the financial losses and obligations created by the insured's death, and is used to determine an acceptable death benefit.

Insurable interest implies:

a degree of financial dependence

Insurance application

a description of the insured's occupation and age, the policy beneficiary, and basic financial data

Exclusion amount

a limit that differentiates larger taxable estates from smaller non-taxable estates

There are two methods commonly used to compute key person insurance needs:

a multiple-of-earnings factor or a business loss approach.

Probate

a process by which a judge verifies the authenticity of the will and by which an executor (if there is a will) or a court appointed administrator (if there is not a will) manages and distributes the estate to the heirs of the deceased.

Liquidation/Stock redemption agreements

allow the company as a whole to purchase the business interest from the estate, and typically the stock is kept as inactive company "treasury" stock. As a result, the surviving owners automatically own a greater percentage of the active ownership shares remaining.

All of the following must be present to obtain life insurance EXCEPT: insurable value purpose of insurance insurable interest anti-selection

anti-selection

In Canada, life insurance is often purchased to offset: property tax estate taxes capital gains tax sales tax

capital gains tax

Disadvantage of HLV

complicated and uses broad assumptions

After the stock market crash, there was an increase in:

death claims due to murder, accidents, and suicide.

Fringe Benefits often structured as:

deferred compensation plans or executive bonus plans.

Common Law

does not and cannot sanction any scheme which has as its purpose the certain infliction of death for financial gain. prohibits individuals from profiting from the death of someone

Cross purchase agreement

each partner or stockholder is obligated to purchase buy-sell coverage on every other partner or stockholder. If one of the business owners dies, the insurance money buys his interest in the company from the estate and transfers it to the remaining owners.

Insurable interest must:

exist at the time of application

Slayers Statute

expand upon the common rule and address unique situations, such as what to do if the beneficiary/murderer is a minor, or insane, or kills in self-defense.

Probate Costs

expenses paid by the estate to hire and retain the lawyers, accountants, and appraisers who work on the estate's valuation and legal representation.

What are the consequences of ignoring insurable interest or exceeding insurable value?

incentive for homicide, suicide, or a fraudulent claim.

Items 1 to 3 comprise the ____. Items 4 to 6 make up the ______.

income statement balance statement or the balance sheet

The concept in which a beneficiary has a substantial financial stake in the continued life of an insured is: antiselection present value insurable interest personal insurance

insurable interest

The type of business insurance that indemnifies a company against the loss of an employee whose skills are critical to the firm is: creditor cross-purchase income replacement key person

key person

Due diligence needed to ensure:

legitimacy relationship appropriate amount

Human Life Value Method

measurement of the earnings potential of the insured's life

Insuring the Non-Working Spouse

needs analysis method is usually used

Fringe Benefit:

non-salary compensation for employees. Common fringe benefits include health insurance, a company car, a travel expense account, life insurance, education expense coverage, and group life insurance.

Needs Analysis Method

not so much on the replacement of the insured's income as it is on satisfying the expenses that will be incurred by the beneficiaries.

nonprofit organizations

organized and operated to further one of these purposes will generally be recognized as charities, exempted from federal income tax, and eligible to receive tax-deductible charitable gifts under Section 501(c)(3) of the Internal Revenue Code.

People in ___ financial situations saw ____ as the only solution

poor life insurance

Multiple of Salary Method

produces a death benefit that provides the proposed insured's family a replacement of income that the proposed insured would have otherwise earned if not for his premature death.

In the US, life insurance is used in the estate planning process for all of the following reasons EXCEPT: offset probate costs provide cash for use by the estate make a charitable bequest replace key person income

replace key person income

Inspection Report

serves as an important check on financial information contained elsewhere in the application or financial statements.

Suicide Clause

states that if the insured commits suicide within two years after the policy is issued, the face amount of insurance will not be paid; there is only a refund of the premiums paid

What is anti-selection?

tendency of individuals, who believe they have a greater than average likelihood of loss, to seek insurance protection to a greater extent than do those who believe they have an average or a less than average likelihood of loss.

Business Loss Approach

the computation of all business losses that would be associated with the death of the key employee that is equivalent to the insurable value of that individual.

Capital Gain

the difference between an asset's purchase price and selling price, when the selling price is greater

In the US, the limit that differentiates larger, taxable estates from smaller non-taxable estates is called: the exclusion amount projected rate of earnings growth the potential for unemployment discount rate for future earnings

the exclusion amount

Key Person Insurance

to indemnify the company against the loss of an employee whose skills and contributions are critical to the firm.

All of the following are reasons that one might have for buying personal life insurance EXCEPT: to pay for children's education and any special needs they may have to replace income that will be lost to the family to make a charitable bequest to provide funds for a company to purchase a partner's business interest from his heirs

to provide funds for a company to purchase a partner's business interest from his heirs

Purpose of creditor insurance

to replace the funds the insured would have provided for the repayment of the loan

Buy-sell insurance

used to buy out partners interest from estate/heirs

Cover Letter

validating the sale and explaining the relevant details of the case.

Loans involving ___ are poor risks

venture capitalists