1 Ins301 Chp15 –Part1 Life Insurance and Annuities Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment insurance Whole life insurance Universal insurance Variable insurance

2 Ins301 Chp15 –Part1 Terminology Death benefit = amount beneficiaries receive Cash value = amount of savings accumulation Death protection = amount of pure death protection = death benefit - cash value Face amount = stated amount of coverage = death benefit (for term, whole life, & some universal life) = death benefit - cash value (for some universal life) Cash surrender value = the amount of money that the policyholder can withdraw (=cash value - surrender penalty)

3 Ins301 Chp15 –Part1 Life Insurance Products: General Introduction Term insurance pure life insurance Cash value life insurance pure life insurance + Savings accumulation whole life universal life variable life Variable universal life

4 Ins301 Chp15 –Part1 Tax Treatment of Life Insurance Death benefits are not taxed Income tax is not paid on increases in cash value while the policy is in force Upon surrender, income tax is paid on Cash surrender value - sum of all premiums + sum of all policyholder dividends

5 Ins301 Chp15 –Part1 Implications of Tax Treatment Implicit returns on savings accumulation Escape taxation if insured dies Tax deferred if the policy is surrendered Partially taxed if policy is surrendered Amount which is taxed is less than implicit return b/c part of premiums is cost of death protection

6 Ins301 Chp15 –Part1 Term Insurance Typically provides pure death protection over a fixed term, usually one year or five years. There is no savings feature and therefore no cash surrender value. Data 1/4 of policies almost half of death protection purchased Guaranteed renewable Premium increases over time. Why?

7 Ins301 Chp15 –Part1 Life Insurance Pricing Ignore expenses and risk load ==> focus on net premiums Use mortality table Probability of dying at age x conditional on living through age x-1 Example: Probability of male dying at age 40 = Assume Premiums paid at beginning of year Claims paid at end of year

8 Ins301 Chp15 –Part1 Pricing 1-Year Term Find fair premium for $100,000 1-year term for 40 year-old Interest rate = 10% Insurers cash flows: Beg. of YearEnd of Year $100,000 with prob Loss $0 with prob Expected claim cost = ________ Premium = Present value of expected claim cost = __________

9 Ins301 Chp15 –Part1 Pricing 1-Year Term Find fair premium for $100,000 1-year term for 41 year-old Interest rate = 10% Insurers cash flows: Beg. of YearEnd of Year -$100,000 with prob ____________ Premium $0 with prob. ____________ Expected claim cost = ___________ Premium = Present value of expected claim cost = ____________

10 Ins301 Chp15 –Part1 Pricing 1-Year Term Premium increases as probability of dying increases

11 Ins301 Chp15 –Part1 Pricing 2-Year Term Find fair premium for $100,000 2-year term for 40 year-old Insurers claim costs: Beg. of Year 1End of Year 1End of Year 2 -$100,000 -$100,000 with prob with prob x $0$0 with prob with prob 1-x

12 Ins301 Chp15 –Part1 Pricing 2-Year Term What is x? – it is the probability of a 40 year-old dying in his 42nd year? Mortality table: NumberNumber Ageof Peopleof Deaths Probability of 40 year-old dying in 41st year =_____ = ______ Probability of 40 year-old dying in 42nd year =_____ = ______

13 Ins301 Chp15 –Part1 Pricing 2-Year Term Single premium Level Premium

14 Ins301 Chp15 –Part1 Endowment Insurance Pays face amount if the insured dies, or if the insured survives the policy period It is similar to a saving account The US no longer grants tax advantage to endowment policies unless they have a very long duration, such as whole life insurance.

15 Ins301 Chp15 –Part1 Whole Life Insurance Policy period ends when insured reaches 100 Equivalent to endowment policy to 100 Premiums single premium limited pay – a level premium paid for a 10-year or 20-year period continuous premium – level premium continue until the policyholder dies, surrenders the policy, or reaches the age of 100 (whichever comes first)

16 Ins301 Chp15 –Part1 Whole Life Insurance Premiums generally do not increase over time But probability of dying increases over time ==> higher upfront premiums than with term Policyholder prepays part of the cost of future death protection entitled to prepayments if policy is surrendered this is the cash value (savings accumulation)

17 Ins301 Chp15 –Part1 Whole Life Insurance If insured dies, beneficiaries receive face amount = death protection + cash value Structured so cash value over time death protection over time

18 Ins301 Chp15 –Part1 Whole Life Insurance

19 Ins301 Chp15 –Part1 Pricing Single Premium Whole Life Apply same principles used with term insurance Forecast expected cash flows to age 100 Find single premium = PV of expected cost Assume no expenses or profits 5% interest rate policy will not lapse

20 Ins301 Chp15 –Part1 Pricing Single Premium Whole Life Single Premium

21 Ins301 Chp15 –Part1 Continuous Level Premium Whole Life Continuous level premium Same premium is paid until insured dies or reaches 100 Equivalent to a life annuity Present value of a life annuity that pays $P starting at age 40 = * P Find P so that PV of premium payments = PV of costs * P = $22,373 ==> P = $1,372.58

22 Ins301 Chp15 –Part1 Limited Payment Whole Life Limited payment level premium Same premium is paid for fixed number of years Example: 20 years Equivalent to a 20 year annuity Present value of a 20-year annuity that pays $P starting at age 40 = $12.58 x P Find P so that PV of premium payments = PV of costs x P = $22,373 ==> P = $1,778.45

23 Ins301 Chp15 –Part1 Comparison of Cash Values in Whole Life

24 Ins301 Chp15 –Part1 How Much Life Insurance Should be Purchased? Rules of thumb Death benefit = 8 times income Forecast beneficiaries sources & uses of funds Uses: Living expenses Education expenses Sources: Social security Earnings

25 Ins301 Chp15 –Part1 Participating Policies Can (and usually does) pay annual dividends always with mutual companies often with stock companies Why? - premiums based on conservative assumptions Key assumptions: interest rate levels and mortality rates These variables are correlated across policyholders Insurers methods of dealing with correlated risk: Bear the correlated risk and hold a lot of capital Share correlated risk with policyholders Illustrated versus actual dividends

26 Ins301 Chp15 –Part1 Other Whole Life Policy Provisions Surrender Options Take cash value Use cash value as a single premium for paid up whole life term policy Policy loans borrow against cash value interest now varies with market rates in 1970s & 80s, fixed rate ==> disintermediation Front-end expense charges ==> Cash value grows slowly at first ==> Implicit return on savings accumulation initially low

27 Ins301 Chp15 –Part1 Universal Life Similar to whole life Main differences: Greater flexibility in premium payments Cash value does not follow a fixed schedule; it varies with policyholders premium payments insurers expense and mortality charges rate insurer uses to credit interest to cash value minimum rate usually guaranteed rate often linked to short term interest rates

28 Ins301 Chp15 –Part1 Factors Affecting UL Cash Value

29 Ins301 Chp15 –Part1 Death Benefit Options with Universal Life Level death benefit (as with Whole Life) Death benefit varies with cash value age Cash value Death benefit

30 Ins301 Chp15 –Part1 Variable Life Similar to whole life Main differences: Cash value does not follow a fixed schedule; it varies with return earned on portfolio of mutual funds chosen by policyholder Death benefit minimum is guaranteed, but varies with cash value

31 Ins301 Chp15 –Part1 Life Insurance and Annuities (part3) What is annuities The purpose of annuity Classification of annuity Overview of annuity contracts

32 Ins301 Chp15 –Part1 What is Annuity An annuity is simply a series of periodic payments. An annuity contract is an insurance policy that promises to make a series of payments for a fixed period or over someones lifetime It is typically used as long-term retirement funding vehicles.

33 Ins301 Chp15 –Part1 Two Periods of Annuity Accumulation period -- the period when the policyholder pays premiums to the insurer Payout period -- the insurer makes payments to the policyholder

34 Ins301 Chp15 –Part1 Purpose of Annuity Risk management purpose Reduce the risk that savings are exhausted before the annuitant dies tax-deferred saving vehicle Returns earned from these contracts are not taxed until the insurer distribute them

35 Ins301 Chp15 –Part1 Classification of Annuity Immediate annuity and deferred annuity Immediate Deferred Flexible premium deferred annuities (FPDAs) Single premium deferred annuities (SPDAs) Fixed annuity and variable annuity Fixed annuity Variable annuity

36 Ins301 Chp15 –Part1 Overview of Annuity Contracts