Risk Management and Insurance - Chapter 11

Types of Term Insurance

- *yearly renewable term: premiums increase each year* - 5-, 10-, 15-, 20- 25-, or 30-year term: premiums paid during the period are level, but increase upon renewal - term to age 65 - *decreasing term insurance: face amount gradually declines each year but premium is level* - reentry term - return of premium insurance: returns the premiums at the end of the term period provided the insurance is still in force (includes only base premiums)

universal life insurance

- a flexible-premium whole life policy that provides lifetime protection under a contract that separates the protection and saving components - contract is an interest-sensitive product that unbundles the projection, saving, and expense components

decreasing term insurance

- a type of annual renewable term life insurance that provides a death benefit that decreases at a predetermined rate over the life of the policy - premiums are usually constant throughout the contract, and reductions in policy payout will typically occur monthly or annually

cash-surrender value

- amount payable to the owner of a cash-value insurance policy if he or she decides the insurance is no longer wanted - *calculated separately from the legal reserve*

whole life insurance

- 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

net amount at risk

- concept associated with a level-premium life insurance policy - calculated as the difference between the face amount of the policy and the legal reserve (*face amount of policy - legal reserve*)

Most Important Family Needs

- estate clearance fund - income during the readjustment period - income during the dependency period - life income to the surviving spouse - special needs (e.g., mortgage redemption fund, educational fund, emergency fund, mentally or physically challenged family members) - retirement needs

Expense Charges in Variable Universal Life Insurance

- front-end load: for sales commissions and expenses - back-end surrender charge: usually exceeds the first-year premium and declines to zero over a 10-20 year period - state premium taxes and federal taxes - investment management fees - mortality and expense charges - administrative costs

legal reserve

- liability item on a life insurer's balance sheet representing the *redundant or excessive premiums* paid under the level-premium method during the early years - assets must be accumulated to offset the legal reserve liability - purpose is to provide lifetime protection

needs approach

- method for estimating amount of life insurance appropriate for a family by analyzing various family needs that must be met if the family head should die and converting them into specific amounts of life insurance - financial assets are considered in determining the amount of life insurance needed

Limitations of Universal Life

- misleading rates of return - decline in interest rates - right to increase the mortality charge - lack of firm commitment to pay premiums

current assumption whole life insurance (aka *interest-sensitive whole life insurance*)

- nonparticipating whole life policy in which the cash values are based on the insurer's current mortality, investment, and expense experience - an accumulation account is credited with a current interest rate that changes over time

Variable Life Insurance Characteristics

- permanent whole life contract with a fixed premium - entire reserve is held in a separate account and is invested - cash-surrender values are not guaranteed, and there are no minimum guaranteed cash values

Paid-up policy versus Matured policy

- policy is "paid-up" when no additional premium payments are required - policy "matures" when the face amount is paid as a death claim or as an endowment

Uses of Ordinary Life Insurance

- provides lifetime protection - saves money

Financial Impact of Premature Death on Different Types of Families

- single people: do not need large amounts of life insurance - single-parent families: group has increased; need for life insurance is great - two-income earners with children: both income-earners need life insurance - blended families (i.e., divorced with children and remarriage): great need for life insurance - sandwiched families (i.e., son / daughter provides financial support to parents): working spouse needs life insurance

Characteristics of Universal Life Insurance

- unbundling of protection and saving component - two forms of universal life insurance - *considerable flexibility (e.g., frequency / amount of premiums, face amount of insurance, change of policy, option to add cash, policy loans)* - cash withdrawals permitted - favorable income-tax treatment

Reasons People Delay Buying Life Insurance

1) Although insurance premiums have declined to historically low levels, consumers believe life insurance is too expensive to purchase 2) Consumers have difficulty in making correct decisions about the purchase of life insurance 3) Many consumers simply procrastinate and never get around to buying life insurance

Three Approaches to Estimate the Amount of Life Insurance

1) Human life value approach 2) Needs approach 3) Capital retention approach

Uses of Term Insurance

1) If the amount of income that can be spent on life insurance is limited, term insurance can be effectively used 2) Term insurance is appropriate if the need for protection is temporary 3) Term insurance can be used to guarantee future insurability

Characteristics of Ordinary Life Insurance

1) Level premiums; excess premiums (since you technically overpay in early years) are accumulated at compound interest and then used to supplement the inadequate premiums paid during the later years of the policy 2) Legal reserve increases, net amount of risk steadily declines 3) Accumulation of cash-surrender values (the amount paid to a policyholder who surrenders the policy)

Characteristics of Variable Universal Life Insurance

1) Selection of investments by policyholders 2) No minimum interest rate or cash value guarantees 3) Relatively high expense charges 4) Substantial investment risk

Limitations of Term Insurance

1) Term insurance premiums increase with age at an increasing rate and eventually reach prohibitive levels 2) Term insurance is inappropriate if you wish to save money for a specific need (e.g., college education) 3) Decreasing term insurance does not provide for changing needs and is not an effective hedge against inflation 4) *does not develop a cash value*

Variations of Whole Life Insurance

1) Variable life insurance 2) Universal life insurance 3) Indexed universal life insurance 4) Variable universal life insurance 5) Current assumption whole life insurance

Steps to Calculating Human Life Value

1. Estimate the individual's average annual earnings over his or her lifetime. 2. Deduct federal and state income taxes, SS taxes, life and health insurance premiums, and the cost of self-maintenance. The rest is used to support the family. 3. Determine the number of years from the person'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.

Limitations of Ordinary Life Insurance

Major limitation: Some people are still underinsured after the policy is purchased

Needs Approach vs. Capital Retention Approach

Methods for determining the amount of life insurance needed: - Needs approach: assumes liquidation of the life insurance proceeds - Capital Retention approach: preserves the capital needed to provide income to the family, and income-producing assets are then available for distribution later to the heirs

Two forms of Universal Life Insurance

Option A: level death benefit, but increases at end Option B: increasing death benefit over time

Variable Universal Life vs. Universal Life

Variable Universal Life is Similar to universal life with the following exceptions: 1) policyholder determines how the premiums are invested --> more flexible 2) does not guarantee a minimum interest rate or minimum cash value

second-to-die life insurance *aka survivorship life*

a form of life insurance that insures two or more lives and pays the death benefit upon the death of the second or last insured

readjustment period

a one- or two-year period following the breadwinner's death

reentry term

a term insurance policy in which renewal premiums are based on select (lower) mortality rates if the insured can periodically demonstrate acceptable evidence of insurability

single-premium whole life insurance

a whole life policy that provides lifetime protection with a single premium payment

variable life insurance

death benefit and cash surrender values vary according to the investment experience of a separate account maintained by the insurer

premature death

defined as the death of a family head with outstanding unfulfilled financial obligations

dependency period

follows the readjustment period; the period until the youngest child reaches age 18

preferred risks

individuals whose mortality experience is expected to be better than average

estate clearance fund (aka cleanup fund)

needed immediately when the family head dies

renewable

policy can be renewed for additional periods without evidence of insurability

term insurance, aka cash-value life insurance

provides temporary protection, while cash-value life insurance has a savings component and builds cash value

variable universal life insurance

similar to universal life insurance with certain exceptions - cash values can be invested in a wide variety of investments - there is no minimum interest rate guarantee - the investment risk falls entirely on the policyholder

convertible

term policy can be exchanged for a cash-value policy without evidence of insurability

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

blackout period

the period from the time that Social Security survivor benefits terminate to the time the benefits are resumed

human life value

the present value of the family's share of the deceased breadwinner's future earnings

endowment insurance

type of life insurance that *pays the face amount of insurance* to the beneficiary if the insured dies within a specified period or to the policyholder if the insured survives to the end of the period

ordinary life insurance

type of whole life insurance providing protection throughout the insured's lifetime and for which premiums are paid throughout the insured's lifetime

limited-payment policy

type of whole life insurance providing protection throughout the insured's lifetime and for which relatively high premiums are paid only for a limited period

modified life policy

whole life policy for which premiums are reduced for the first three to five years and are higher thereafter