FIN335: 3

what types of families need life insurance

-Single person -Single-parent family -Two income earners with children -Traditional family -Blended family -Sandwiched family

cash surrender value

For life insurance, the quantity that the owner is able to get if the policy does not remain in force until the insured's death. For annuities, the amount of a deferred annuity's accrued value that the contract holder is able to get if the policy is relinquished during its accumulation period.

Requirements of insurance contracts

To be legally enforceable, an insurance contract must: -exchange of consideration: the values that each party exchange -competent parties: with legal capacity to enter into a binding purpose -legal purpose: contract must exist for a legal purpose - offer and acceptance of the terms of the contract

Definition of "Insured"

an insurance contract must indicate the persons or persons from whom the protection is provided - some policies insure only one person ex: most life insurance policies - the named insured is the person or persons named in the declarationsection of policy - policy may cover other parties even though they are not specifically named

annual aggregate deductible

means that all losses that occur during a specified time period are accumulated to satisfy the deductible amount

Law and insurance agent: Estoppel

occurs when a representation of fact made by one person to another person is reasonably relied on by that person to such an extent that it would be inequitable to allow the first person to deny the truth of the representation

Principle of Utmost Good Faith: Warranty

- a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects - statements made by applicants are considered representations not warranties

Principle of Utmost Good Faith

- a higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts - supported by 3 legal doctrines

Law and insurance agent

- an agent is someone who has authority to act on behalf of a principal (the insurer) - several laws govern the actions of agents and their relationship to insureds: * There is no presumption of an agency relationship * An agent must be authorized to represent the principal, authority is either express, implied or apparent * Knowledge of the agent is presumed to be knowledge of the principal with respect to matters within the scope of the agency relationship

Insured Interest and purpose

- insured must stand to lose financially if a loss occurs - purpose: to prevent gambling, reduce moral hazard, measure amount of loss - insurable interest exists in property insurance at the time of the loss and in life insurance only at inception of the policy

Principle of Utmost Good Faith: Concealment

- intentional failure of the applicant for insurance to reveal a material fact to the insurer

Principle of Utmost Good Faith: Representations & Misrepresentations:

- statements made by the applicant for insurance - a contract is voidable if the representation is material, false, and relied on by the insurer - innocent misrepresentation of a material fact, if relied on by the insurer, makes the contract voidable

Subrogation

- substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third person for a loss covered by insurance - insurer is entitled only to the amount it had paid under the policy - purpose is to prevent insured from collecting twice for same loss, to hold negligent person responsible for the loss, and to hold down insurance rates

costs associated with variable annuities

-Investment management charge, for brokerage services -Administrative charge, for paperwork, etc. -Mortality and expense risk charge, to pay for •The mortality risk associated with the death benefit •A guarantee on the maximum annual expenses •An allowance for profit -Surrender charge, if annuity is surrendered in the early years of the contract •Total fees and expenses in most variable annuities are high

non-qualified annuities

-Investment management charge, for brokerage services -Administrative charge, for paperwork, etc. -Mortality and expense risk charge, to pay for •The mortality risk associated with the death benefit •A guarantee on the maximum annual expenses •An allowance for profit -Surrender charge, if annuity is surrendered in the early years of the contract •Total fees and expenses in most variable annuities are high

Valued pricing

-exception to indemnity - pays the face amount of insurance if a total loss occurs - life insurance contract is a valued policy that pays a stated sum to beneficiary upon the insured's death

Replacement cost less depreciation

-method to determine actual cash value for indemnification - no deduction for depreciation in determining the amount paid for a loss

Fair market Value

-method to determine actual cash value for indemnification - price a willing buyer would pay a willing seller in a free market

Broad evidence rule

-method to determine actual cash value for indemnification - the determination of ACV should include all relevant factors an expert would use to determine the value of the property

deferred annuity

-provides income payments at some future date •A deferred annuity purchase with a lump sum is called a single-premium deferred annuity •A flexible-premium annuity allows the owner to vary the premium payments

parts of an insurance contract: Exclusions

3 major types: - excluded perils ex: flood - exluded losses ex: professional liability loss is exluded in the homeowners policy - excluded property ex: pets are not covered as perosnal property in the homeowners policy Necessary because: - some perils not commercially insurable ex: catastrophic losses due to war - extraordinary hazards are present ex: using the automobile for a taxi - coverage is provided by other contracts ex: use of auto excluded on homeowners policy - moral hazard is present or it would be difficult to measure the amoutn fo loss Ex: coverage of money limited to 200$ in homeowners policy -coverage not needed by typical insureds ex: homeowners policy does not cover aircraft

single premium

A lump sum payment is made into an annuity

economic justification for life insurance- lost economics

Life expectancy has increased significantly over the past century -Thus, the economic problem of premature death has declined -Millions of Americans still die annually from heart disease, cancer and stroke •The purchase of life insurance is financially justified if the insured has earned income and others are dependent on those earnings for financial support

Whole life: Legal Reserve

The excess premiums paid during the early years are used to supplement the inadequate premiums paid during the later years of the policy

health insurance: corridor deductible

can be used to integrate a basic medical expense plan with a supplemental major medical expense plan

life insurance: whole life (cash value) - uses and limitations

has a savings component and builds cash values •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

Coinsurance

in a property insurance contract encourages the insured to insure the property to a stated percentage of its insurable value - if coinsurance requirement is not met at the time of the loss, the insured must share in the loss as a coinsurer -purpose is to achieve equity in rating; if coinsurance requirement met, the insured receives a rate discount and the policyowner who is underinsured is penalized through application of coinsurance formula

Coordination fo benefits provision

in group health insurance is designed to prevent overinsurance and the duplication of benefits if one person is covered under more than one group health insurance plan - ex two employed spouses insured as dependednts under each others gorup healh insurance plan

Riders

in life and health insurance, is a provision that amends or changed the original policy -ex: waiver of premium rider on a life insurance policy

Endorsements

in property and liability insurance, written provision that adds to, deletes from, or modifies the provisions in the original contract - ex: an earthquake endorsement to a homeowners policy

immediate annuity

income payments can be paid immediately, or at a future date

straight deductible

insured must pay a certain amount before the insurer makes a loss payment -ex: auto insurance deductible

Indemnity

insurer agrees to pay no more than the actual amount of the loss - purpose is to prevent insured from profiting from a loss and to reduce moral hazard

Distinct Legal Characteristic of Insurance Contract: Unilateral

only the insurer makes a legally enforceable promise

Distinct Legal Characteristic of Insurance Contract: Conditional

policyowner must comply with all policy provisions to collect for a covered loss

Primary and excess coverage

primary insurer pays first and the excess insurer pays only after the policy limits under the primary policy are exhausted

Distinct Legal Characteristic of Insurance Contract: Personal

property insurance policy cannot be validly assigned to another party without the insurer's consent

life insurance: term - uses and limitaitons

provide temporary protection -Protection expires at the end of the policy period, unless renewed -Most term policies are renewable for additional periods •Premiums increase at each renewal -Most term policies are convertible, which means 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 •Under the 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 •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

life annuity

provides a life income to the annuitant only while the annuitant remains alive

Deductibles: purpose,

provision by which a specified amount is subtracted from the total loss payment that otherwise would be payable purpose is to: - eliminate small claims that are expensive to handle and process - reduce premiums by the insured: under the large loss principle, insurance should pay for high severity losses, small losses can be budgeted out of the person's income - reduce moral and morale hazard

parts of an insurance contract: Conditions

provisions in the policy that qualify or place limitations on the insurers promise ot perform - if policy conditions not mmet, insurer can refuse to pay the claim insurance policies contain a variety of misc. provisions -ex: cancellation, subrogation, grace period, misstatemtn of age

health insurance: percentage participation clause

requires insured to pay certain percentage of covered medical expenses in excess of the deductible - purpose is to reduce premiums and prevent overutilization of policy benefits

Insurance to pay estate taxes

rich people

Distinct Legal Characteristic of Insurance Contract: Adhesion

since the insured must accept the entire contract as written, any ambiguities are contrued against the insurer

health insurance: waiting/elimination periods

stated period of time at the beginning of a loss during which no insurance benefits are paid

parts of an insurance contract: Declaration Page

statements that provide information about the particular property or activity to be insured - usually first page of policy - in property insurance contains name, location, period of protection, amount of insurance, premium and deductible info

parts of an insurance contract: Insuring Agreement

summarizes major promises fo the insurer 2 basic forms of agreement in property insurance: - named perils policy: where only those perils specifically named in the policy are covered - all risks policy where all losses are covered except those losses specifically excluded, may also be called an open perils policy or special coverage policy, has fewer gaps and the burden of proof is placed on the insurer to deny a claim

parts of an insurance contract: Definitions

typically a page or section for this, ex the insured is reffered to as you

Distinct Legal Characteristic of Insurance Contract: Aleatory

values exchanged are not equal

Law and insurance agent: waiver

voluntary relinquishment of a known legal right

annuities: variable

• pays a lifetime income, but the income payments vary depending on common stock prices -The purpose is to provide an inflation hedge by maintaining the real purchasing power of the payments -Premiums are used to purchase accumulation units during the period prior to retirement •The value of an accumulation unit depends on common stock prices at the time of purchase -At retirement, the accumulation units are converted into annuity units •The number of annuity units remains constant during the liquidation period, but the value of each unit changes with common stock prices

IRA

•An individual retirement account allows workers with taxable compensation to make annual contributions to a retirement plan up to certain limits and receive favorable income-tax treatment

TVM: FV, PV, PMT, I, N

•If I had $10,000 to invest and a goal of growing it to $20,000 in 7-years. How much interest or investment return do I need to achieve $20,000 in 7 years? PV: -10,000 FV: 20,000 N: 7 CPT I: 10.409%

amount you think you need: needs approach

•The amount needed depends on the financial needs that must be met if the family head should die •Important family needs must 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 -The dependency period is the period until the youngest child reaches age 18 -Life income to the surviving spouse, including income during and after the blackout period. The blackout period refers to the period from the time that Social Security survivor benefits terminate to the time the benefits are resumed -Families should also consider special needs, e.g., funds for college education and emergencies

amount you think you need: 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 individual's 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

premature death

•The death of a family head with outstanding unfulfilled financial obligations can cause serious financial problems for the surviving family members -The deceased's future earnings are lost forever -Additional expenses are 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

amount you think you need: capital retention

•This approach preserves the capital needed to provide income to the family -Income-producing assets are preserved for the heirs •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 -Internet-based life insurance calculators produce widely-varying results, but may be a good starting point

IRAS: Traditional (tax rules, age and income limits, and consequences; investment risk)

•allows workers to take a tax deduction for part or all of their IRA contributions -The investment income accumulates income-tax free on a tax-deferred basis -Distributions are taxed as ordinary income -The participant must have earned income during the year, and must be under age 70½ -For 2007, the maximum annual contribution is $4000 or 100 percent of earned compensation, whichever is less •Workers over 50 can contribute up to $5000 -A full deduction for IRA contributions is allowed if: •The worker is not an active participant in an employer's retirement plan The worker's modified adjusted gross income is below certain thresholds •Distributions from traditional IRAs are treated as ordinary income -Any nondeductible contributions are received income-tax free -A formula is used to compute the taxable and nontaxable portions of each distribution •Traditional IRAs can be established at a bank, mutual fund, stock brokerage firm, or insurer •The IRA can be set up as either: -An individual retirement account -An individual retirement annuity •IRA contributions can be invested in a variety of investments •An IRA rollover account is an account established with funds distributed from another retirement plan

Variations of Whole life Insurance: variable universal

•an important variation of whole life insurance -Most are sold as investments -Similar to universal life except that: •The policy owner decides how the premiums are 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

taxation of individual annuities: exlusion ratio

•exclusion ratio is used to determine the taxable and nontaxable portions of the payments Exclusion ratio= investment in contract/ expected return •Annuities can be attractive to investors who have made maximum contributions to other tax-advantaged plans

annuities: equity-indexed

•is a fixed, deferred annuity that: -allows the owner to participate in the growth of the stock market •A cap specifies the maximum percentage of gain that is credited to the contract -provides downside protection against the loss of principal and prior interest earnings if the annuity is held to term •The participation rate is the percent of increase in the stock index that is credited to the contract •Insurers use different indexing methods to credit excess interest to the annuity •Equity-indexed annuities with terms longer than one year have a guaranteed minimum value

Variations of Whole life Insurance: vairable

•is 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 •If the investment experience is favorable, the face amount of insurance is increased -Cash surrender values are not guaranteed •Although the insurer bears the risk of excessive mortality and expenses, the policyholder bears the risk of poor investment results

Variations of Whole life Insurance: universal

•is 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 -The protection and savings components are unbundled •the policyholder's statement shows the premiums paid, death benefit, and value of the cash value account •It also shows the mortality charge and the interest credited to the cash value account - two forms of universal life insurance: option a and b -provides considerable flexibility •Cash withdrawals are permitted •Policies receive favorable federal income tax treatment -Limitations •Insurers advertise misleading rates of return •Cash-value and premium-payment projections based on higher interest rates are misleading and invalid •Insurers can increase the current mortality charge to recoup expenses •A policy may lapse because some policyowners do not have a firm commitment to pay premiums

ordinary life insurance

•is a level-premium policy that provides lifetime protection -Premiums are level throughout the premium paying period -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 -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 •Because of the loading for expenses and high first-year acquisition costs, cash values are initially below the legal reserve •The policyowner has the right to borrow the cash value or exercise a cash surrender options -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 -A term policy for the same premium would purchase substantially more protection

IRAS: Roth

•is another type of IRA that provides substantial tax advantages -The annual contributions to a Roth IRA are not tax deductible -The investment income accumulates income-tax free -Qualified distributions are not taxable under certain conditions -Contributions can be made after age 70½ -Roth IRAs have generous income limits -A traditional IRA can be converted to a Roth IRA

annuities: fixed income

•pays periodic income payments that are guaranteed and fixed in amount -During the accumulation period prior to retirement, premiums are credited with interest -pays a higher interest rate initially -The liquidation period is the period in which funds are paid out, or annuitized - income payments can be paid immediately, or at a future date