Amount of Life Insurance to Own

Endowment Insurance

A traditional form of life insurance. Pays the face amount of insurance if the insured dies within a specific period; if the insured survives to the end of the endowment period, the face amount is paid to policy owner at that time.

Limited-payment life insurance

A type of traditional whole life insurance that is permanent and provides lifetime protection. Premiums are level but paid only for a certain period. Premiums are high for substantially lower coverage levels in contrast to an ordinary life policy.

Variable Life Common Features

A variable life policy is a permanent whole life contract with a fixed premium. The premium is level and is guaranteed not to increase. The entire reserve is held in a separate account and is invested in common stocks or other investments. The policy owner generally has the option of investing the cash value in a variety of investments. The minimum death benefit will be at least equal to the original face amount, but it can be considerably higher depending on the investment experience of the account. Cash surrender values are not guaranteed, and there are no minimum guaranteed cash values. Although the risk of excessive mortality and expenses is borne by the insurer, the investment risk is retained entirely by the policy owner.

Capital Retention Approach

Aka capital needs analysis Preserves the capital needed to provide income to the family. The income-producing assets are then available for distribution later to the heirs.

Conversion Privilege

Allows employee to convert group term life insurance to an individual permanent policy if employees coverage ceases due to termination of employment, termination of membership in a classification(s) eligible for coverage or retirement. Employee must apply in writing to the insurer within 30 days of termination and pay the premium for his or her attained are, type of insurance, class of risk, etc. Employers are required by law in most states to notify employees of their conversion rights within 30 days after they take effect.

Accelerated Benefits

Allows for the payment of all or part of the death benefit if a patient can prove that he or she has a terminal illness that is typically expected to result in death within 12 months and can be certified by a physician.

Ordinary Life Insurance

Also called continuous premium whole life and straight life. Is a level premium policy that provides lifetime protection to age 100. If policy owner is still alive at 100, the face amount of insurance is paid to the policy holder at that time.

Universal Life Insurance

Also called flexible premium life insurance. Defined as a flexible premium policy that provides protection under a contract that unbundled the protection and savings components. Except for the first premium, the policy owner determines the amount and frequency of payments. The premiums, less explicit expense charges, are credited to a cash value account (also called an accumulation fund) from which monthly mortality charges are deducted and to which monthly interest is credited. In addition, universal life policies typically have a monthly deduction for administrative expenses.

Advantage of Human Life Value

Crudely measures the economic value of a human life

Financing

Employee benefit programs, including group term life, may be financed on either a noncontributory basis (employer pays the total amount for the insurance) or contributory basis (where the employees share the cost with the employer or, in some plans, may pay the entire cost.

Assets

Include homes, real estate, automobiles, personal/household property, securities/investments, 401k plan, pension plans, individual and group life insurance Checking accounts.

Use of Term Insurance

Income is limited - term insurance affordable. Temporary needs - such as decreasing term insurance can be effectively used to pay off the mortgage if the family head dies prematurely. Used to guarantee future insurability. An individual with limited income can purchase term insurance and convert later into permanent insurance policy without EOI.

Readjustment Period (income)

Is a one or two year period following the breadwinner's death when the family should receive approximately the same amount of income received while the family head was alive.

Advantages of contributory approach

Larger benefits possible if both employers and employees contribute. Employees may have more control and greater employee interest. Better use of employer's contributions provided enough individuals participate to meet the non discrimination requirements - may allow employer to provide more coverage to the employees with the greatest needs. Greater employee interest if they are contributing to the plan.

DEFRA 1984

The deficit reduction act of 1984 - repealed scheduled 15% net interest exclusion ($900 cap) Reduced benefits from income averaging Reduced tax benefits for property leased by tax exempt entities Temporarily extended telephone excise tax (through 1987) Increased depreciation lives for real property from 15 years to 18 years

Net Amount of Risk

The difference between the legal reserve and face amount of insurance.

Decreasing term insurance

The face amount gradually declines each year. The premium is level throughout period. Structured so policy is fully paid for a few years before coverage expires. Avoids paying a relatively large premium for only a small amount of insurance near end of term period.

Educational fund

The family head may wish to provide an educational fund for the children. If the children plan to attend a private college or university, the cost will be considerably higher than at a public institution.

Needs Approach

The needs approach for estimating the amount of life insurance to own is focused on having an amount that is sufficient, along with other sources of income and financial assets, to meet the basic family needs of dependent survivors of the insured. The amount of money needed to meet these needs is determined. The total amount of existing life insurance and financial assets is then subtracted from from the total amount needed. The difference is the amount of new life insurance that should be purchased. Assumes liquidation of the life insurance proceeds.

Social Security Blackout Period

The period from the time that Social Security survivor benefits terminate to the time that the benefits are resumed. Social security benefits to a surviving spouse terminate when the youngest child reaches age 16 and start again when the spouse attains age 60.

Original-age Method

The premium charged (to convert a term policy to a cash value policy) is based on the insured's original age when the term insurance was first purchased. Also requires the policy owner to pay the difference between the premiums paid on the term policy (prior to conversion) and those that would have been paid on the new policy, with interest, at a specified rate. The purpose of the financial adjustment is to place the insurer in the same financial position it would have achieved if the policy had been issued at the original age.

Attained-age Method

The premium charged (to convert a term policy to a cash-value policy) is based on the insured's age at time of conversion.

Universal Life Insurance Characteristics

Unbundling of protection and saving component Two forms of universal life insurance Considerable flexibility Cash withdrawals permitted Favorable income-tax treatment

Universal Life Insurance (UL)

Universal Life is a flexible premium policy that provides lifetime protection under a contract that separates the protection and savings components with unbundled components of mortality, expenses and interest. Option A has a level total death benefit, unless the cash value forces the corridor rules to apply which increase the death benefit amount) and Option B, which has a death benefit amount usually equal to the face amount plus the cash value, may also trigger what is called the corridor if the cash value grows. This is an equity based product where cash withdrawals and cash value borrowing is permitted. In addition if this is viewed as an insurance product and not an investment, there remains favorable income tax treatment.

Variable Life Insurance (VL)

Variable life, a fixed premium policy in which the death benefit and cash surrender values vary according to the investment experience of a separate account maintained by the insured.

Uses of Ordinary Life Insurance

When lifetime protection is needed beyond 65 or 70. Can be used to save money. Builds cash values that can be obtained by surrendering the policy or by borrowing the cash value.

Needs Approach Considerations

1. Estate clearance fund 2. Income during the readjustment period 3. Income during the dependency period 4. Life income to the surviving spouse 5. Special needs: Mortgage redemption fund, educational fund, emergency fund 6. Retirement needs

Common Limited-Payment Policies

10, 20, 25 or 30.

Settlement Options

Employee or beneficiary can elect to receive the face amount of group term life insurance on an installment basis rather than a lump sum. Installments are paid according to tables listed in the group master policy. An insurer generally offers optional modes of settlement based on life contingencies. The basis is seldom mentioned or guaranteed in the contract and is governed by insurance company practices at the time of death. Depending on the state law governing the contract, insurers may pay interest on funds held between date of death and the date the claim is paid as a lump sum or converted into a life annuity or installment settlement option.

Capital Retention Disadvantage

Larger amount of life insurance is required to produce a given amount of income. Families are unable to afford the additional amount of life insurance.

Estate Clearance Fund

Or cleanup fund is needed immediately when the family head dies. Immediate cash is needed for burial expenses; uninsured medical bills; installment debts; estate administration expenses; and estate, inheritance, and income taxes.

Disability Income Provision

Other income provision

Capital Retention Advantages

Simplicity, ease of understanding, preservation of capital. Investment income earned on the emergency and educational funds can be used as a partial hedge against inflation, or it can be accumulated to offset rising educational costs.

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 insured dies.

Emergency Fund

A family should have an emergency fund for unexpected events that require large amounts of cash such as dental work, home repairs, new car.

Single Premium whole life insurance

A form of limited-payment insurance that provides lifetime protection with a single premium.

Advantages of non-contributory approach

All employees insured - all eligible employees who have completed the probationary period and are actively at work have coverage. tax advantages - employer premium costs are deductible as an ordinary business expense for federal income tax purposes, simplicity of administration, economy of installation and greater control of the plan.

Retirement needs

Because the family head may survive until retirement, the need for adequate retirement income should be considered. Most retired workers are eligible for social security retirement benefits and may also be eligible for retirement benefits from their employer. If retirement income from both sources is inadequate, additional income from cash-value life insurance, individual investments, a retirement annuity, or an individual retirement account (IRA).

Benefit schedule factors

Employee's needs Overall cost of the plan Non-discrimination requirements of the law Employees ability to pay if the plan is contributory The interrelationship of the four factors results in benefit schedules that are related to 1) earnings (typically limited to a maximum amount), 2) occupation or position, or 3) a flat benefit amount for everyone covered. Computerized benefits administration systems of today allow for benefits to be a direct multiple of an employee's salary, usually rounded to the nearest hundred dollars.

Assignment

Group term life insurance may be assigned if permitted by both the master policy and state law. The right to assign group life insurance is important as a means for an employee to remove the group life insurance proceeds from his or her gross estate for federal estate-tax purposes. A properly executed absolute assignment conveys all incidents of ownership in group term life insurance to another person or to an irrevocable insurance trust. This is an important estate planning technique for some employees whose estates are potentially subject to federal estate taxation.

Cash-Value Life Insurance

Provides a savings component and builds cash values.

Corridor

The ratio of cash to death benefit such that if the cash grows, depending on a person's age, there is a minimum death benefit that must be available. If it is lower than the appropriate amount needed to support the cash value, to keep the insurance contact as one where in tax advantages are preserved, the death benefit must be increased...the increase is called the corridor. The latter is more costly in the years that the net amount of risk is greater than the former.

Policy Maturity

When the face amount is paid as a death claim or an an endowment.

Human Life Value Calculations

1. Estimate average annual earnings over an individual's productive lifetime. 2. Deduct federal and state income taxes, Social Security taxes, life and health insurance premiums, and the costs of self-maintenance. The remaining amount is used to support the family. 3. Determine the number of years from the individual's present age to the contemplated age of retirement. 4. Using a reasonable discount rate, determine the present value of the family's share of earnings for the period determined in step 3. Example: Age 27; $50,000 annually. Retire at 67. Earnings remain constant. Of this amount, $20,000 is used for federal and state taxes, life and health insurance, and individual's personal needs. Remaining $30,000 is used to support family (wife, two children). This stream of future income is then discounted back to the present to determine human life value. Using a reasonable discount rate of 5%, the present value of 40 annual payments of $1 at the end of each year is $17.16. The human life value of $514,800 ($30,000 x $17.16=$514,800).

Limitations of Human Life Value

1. Other sources of income are ignored (Social Security survivor benefits and private pensions death benefits). 2. In it's simplest form, work earnings and expenses are assumed to be constant and employee benefits are ignored. 3. Amount of money allocated to the family can quickly change because of divorce, birth or death of a family member. 4. The long run discount rate is critical; the human life value can be substantially increased by assuming a lower rate. 5. Effects of inflation on earnings and expenses are ignored.

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 death benefit and cash surrender values will increase or decrease with the investment experience of the separate account.

Paid-Up Policy at 65

A form of limited-payment insurance.

Fundamental purpose of the legal reserve

A legal reserve is a composite liability account of the insurer of which the purpose is to provide lifetime protection. Recognizing that premiums paid during the early policy years are higher than is necessary to pay death claims, the 'excess premiums' paid in the early years are invested and the accumulated funds are used to supplement the inadequate premiums paid during the later years of the policy. State laws regulate the investing and accumulating the fund, which is hence called the legal reserve. The difference between the face amount of the policy and the legal reserve is the net amount of risk. As the death rate increases with age, the legal reserve or savings component steadily increases, and the pure insurance portion called the net amount of risk steadily declines. The net amount at risk is the difference between the legal reserve and face amount of insurance.

Paid Up Policy

A limited term policy (20-year limited policy) for $25,000 is paid in full at 20 years and no additional premiums are required. The policy remains in force.

Waiver of Premium Provision

Employees may become disabled during the Group Term Life Insurance plan period. 93% of today's plans have a waiver of premium provision. The life insurance remains in force if. 1)employee is under a specified age such as 60 or 65, at the date of commencement of total disability; 2) total disability commences while the person is covered; 3) total disability is continuous until the date of death; and 4) proof of total and continuous disability is presented at least once every 12 months.

Dependency Period (income)

Follows the readjustment period; it is the period until the youngest child reaches age 18. The family should receive income during this period so that the surviving spouse can remain at home, if necessary, to care for the children. The income needed is substantially reduced if surviving spouse is already in the labor force and plans to continue working.

Needs Approach Disadvantage

Future projections over the insured's lifetime require numerous assumptions and detailed calculations requiring the use of a computer. Dynamic programming models with changing assumptions are complex and usually are not needed by the typical insured.

Purpose of readjustment period

Give family time to adjust its living standard to a different level (after breadwinner's death).

Thirty One Day Continuation of Protection

Gives a terminated employee an additional 31 days of protection while evaluating the conversion privilege or awaiting coverage under the group life insurance plan of the new employer.

Continuation of Insurance

Gives employer option to continue the employees group term life insurance for a limited period if negotiated with carrier on a basis that precludes adverse selection during temporary interruptions of continuous active full time employment. Upon expiration of the continuation period, premium payments are discontinued and the employee's insurance is terminated, then subject to the conversion or portability features of the contract. However, in this event, the insurance, as well as right to exercise the conversion privilege, is still extended for 31 days after termination of the insurance.

Employer Group Life Insurance

Group term life insurance Group dependent life insurance Group accidental death & dismemberment insurance Group travel accident insurance Joint and survivor annuity benefits under retirement plans Preretirement annuity benefits Supplemental/optional life insurance for employees and dependents

Beneficiary Designation

Group term life insurance calls for the employee to designate a primary beneficiary in the event of death. This can be changed anytime. Restriction is that insurance must benefit someone other than the employer. If a beneficiary is named but does not survive and no contingent is listed proceeds may be payable at the insurer's option to any one or more of the following surviving relatives of the employee: spouse, mother, father, child or children, executor or administrator of the estate of the deceased employee. If any beneficiary is a minor or otherwise incapable of giving a valid release, the insurer can pay processed under a 'facility of payment' clause subject to certain limits.

Variable Universal life insurance (VUL)

Has characteristics of both: it is equity based - the owner may designate specific investment funds; and characteristics of the universal life in that it is unbundled. Note: there usually is not a guarantee on the minimum interest-crediting rate.

Human Life Value Approach

Human life value can be defined as the present value of the family's share of the deceased breadwinner's future earnings.

Disadvantages of decreasing term insurance

If one becomes uninsurable, you must convert the remaining insurance to a permanent plan to freeze the remaining amount of insurance otherwise the policy continues to decrease in value. Does not account for life events or rate of inflation.

Five Essential Features of Group Life Insurance

Makes use of group selection whereby an entire group can be insured without medical examination or other EOI. Premiums on a plan are subject to experience rating. The larger the group the greater the degree to which its cost of insurance reflects its own loss experience. Experience rating is either prospective or retrospective. Prospective is when the experience has been favorable and an experience credit (dividend) may be paid at the end of the year to adjust the renewal premium for the next year. Retrospective is if the experience credits may be applied to current year's original premium. This type of rating is rare in current times. Calls for economies of administration. The plan is administered by an insurance company, an employer, a union or other agency positioned to obtain administrative efficiencies through payroll deductions or other centralized functions. Today's plans are underwritten for 100% employee contribution - employees have option of opting out of coverage or selecting coverage they want. This opens the plan up to possible adverse selection caused by the younger, healthier employees opting out leaving the older and potentially less healthy employees in the plan. Best practice today considers these changing factors. Calls for Master Contract - also called certificate of coverage. Individuals receive a group certificate as proof that they are covered, coverages provided, amounts of coverage, plan features, etc. Insured employees also receive a summary plan description (SPD) booklet describing the plan in relatively easy-to-read language. Master Contracts indicates that the plan may last long beyond the lifetime (or participation in the group) of any one individual, although any group life contract can generally be cancelled by the employer or plan sponsor, or by the insurance carrier.

Universal Life Limitations

Misleading rates of return. The advertised rates are gross rates, not net rates. This overstates the rate of return on the savings component because it does not reflect deductions for sales commissions, expenses and the cost of insurance protection. Decline in interest rates. Many earlier sales presentations showed sizable future cash values based on relatively high interest rates. The interest rates have declined over time, making the earlier cash-value and premium-payment projections based on higher interest rates misleading and invalid. Right to increase the mortality charge. Insurers can increase current mortality charge up to a maximum limit. Other expenses may be hidden in the mortality charge. If insurers expenses increase, the mortality charge could be increased to recoup expenses. This is misleading to the insured who will assume the rate increases due to their age. Lack of firm commitment to pay premiums. Some policy owners do not have a firm commitment to pay premiums. Policies may lapse because of nonpayment of premiums. Payments can be skipped or reduced in a UL policy and eventually monies need to be added to account or policy will lapse.

Liabilities

Mortgages, auto loans, credit cards, final expenses (burial, funeral), emergency fund, educational fund, non-income producing capital (automobiles, personal/household property, value of home).

Extended death benefit

Pays group life insurance death claims incurred within one year after termination of employment. It requires that the employee be continuously and totally disabled from the date of termination of employment until death occurs.

Level Premium Method

Premiums are level - do not increase with age. Insured has lifetime protection to what usually is age 120. Can be purchased for 5, 10, 15, 20, 25 or 30 years. Premiums paid during period are level, but increase when the policy is renewed.

Characteristics of Ordinary Life Insurance

Premiums are level throughout the premium-paying period. The insured is actuarial lay overcharged during the yearly years and undercharged during the later years.

Limitations of Term Insurance

Premiums increase with age at an increasing rate eventually becoming cost prohibitive. Not suitable beyond 65. Premiums increase from 5 - 15% due to higher cost of capital, higher reinsurance costs, lower investment returns. Does not accumulate cash value.

Capital Retention Analysis Steps

Prepare a personal balance sheet that includes all assets and liabilities at time of death plus all death benefits income from all resources. Determine the amount of income producing capital (assets) by subtracting the liabilities, cash needs, and non-income producing capital from total assets. The balance remaining is the capital available for income. Determine the amount of additional capital needed by comparison of the income objective with other sources of income (Social security survivor benefits, etc.). This is determined by subtracting capital income

Life Income to Surviving Spouse

Provide life income to the surviving spouse if they are older and out of the labor force for many years. Two income periods: Income during the blackout period; income to supplement social security benefit after the blackout period. If a surviving spouse is already in the labor force, the need for life income is reduced or eliminated. An older spouse under age 60 who has been out of the labor force for years and for whom social security survivor benefits have temporarily terminated.

Yearly Renewable Term

Provides life insurance protection for only one year. Renewable without EOI. Premium based on obtained age. Increase gradually during early years then sharply during later years. Not a good choice for lifetime protection as premiums eventually become cost prohibitive.

Term to age 65

Provides protection to age 65 only. Can be converted to a permanent plan of insurance but the decision to convert must be exercised before age 65.

Term Insurance

Provides temporary protection (10, 20, 30). The period purchased is temporary through the term. Unless the policy is renewed, the protection expires at end of period. Most renewable without EOI and premium is age based. Renewal provision purpose is to protect the insurability of the insured; results in adverse selection against the insurer. Adverse selection is prevented by insurers by age limits on renewals to age 70 or 80. Convertible - term policy can be exchanged for a cash-value policy without EOI. No cash value or savings element.

Limitations of Ordinary Life Insurance

Purchasing an ordinary life insurance policy due to long-term savings feature at a higher premium rate when term life insurance may be more appropriate for the insured's situation.

Needs Approach Advantage

Reasonably accurate method for determining the amount of life insurance to own when specific family needs and objectives are recognized. Other advantages are that it considers other sources of income and financial assets.

Opportunity Cost

Refers to what the insured policy owner gives up when life insurance is purchased.

Reentry term

Renewal premiums are based on select (lower) mortality rates if the insured can periodically demonstrate acceptable evidence of insurability.

Return of premium term insurance

Returns the premiums at the end of the term period provided the insurance is still in force. 15, 20, 25, 30 years. Partial refund possible if policy not kept in force to the end of the period and only includes base premiums excludes riders or substandard premiums.

Variable Universal Life Insurance

Similar to a universal life policy with two major exceptions: 1)policy owner determines how the premiums are invested, which provides considerable investment flexibility and 2) the policy does not guarantee a minimum interest rate or minimum cash value. One exception is that the policy may have a fixed income account, which may guarantee a minimum interest rate on the account value Most VUL are set up as tax shelters or sold as investments. Selection of Investments by Policyowner - Allows policy owner to invest the premiums in a wide variety of investments. The premiums are invested in one or more separate accounts, similar to mutual funds in their daily operations. Insurers typically have 10 or more separate accounts available to include: common stock fund, bond fund, balanced fund, international fund, real estate fund, money market fund, and other accounts. Some insurers also use the mutual funds of investment companies as sub accounts, such as mutual funds sold by Fidelity Investments and the Vanguard Group. The premiums purchase accumulation units, which reflect the value of the underlying investments. The policy owner can switch out of the different funds without incurring an income-tax liability, such as switching out of a bond fund into a money market fund if interest rates are expected to rise. No Minimum Interest Rate or Cash Value Guarantees - a variable universal life policy has no guaranteed minimum interest rate and no guaranteed minimum cash value. However, a fixed-income account may guarantee a minimum interest rate on the value of the account. Relatively High Expenses Charges - reduces investment returns and erode the favorable tax treatment under the policy. As a Tax Shelter - investment earnings are not currently taxable as income to the Policyowner. If policy stays in force until death, no federal income taxes are ever payable even if the separate account has sizable capital gains.

Mortgage redemption fund

The amount of monthly income needed by surviving family members is greatly reduced when monthly mortgage payments or rent payments are not required