Chapter 11

Learning Objectives (part 1 of 3) Describe when a person should and should not have life insurance Describe the basic differences between a term and a cash value policy Describe the various types of cash value policies Discuss the appropriateness of borrowing against a whole life policy

Learning Objectives (part 2 of 3) Describe participating policies, riders, and viatical settlements Compute the value associated with buying term and investing the difference Compute how much life insurance a person should have Discuss whether a survivor should pay off a mortgage

Learning Objectives (part 3 of 3) Describe the way a life insurance company rates a person Describe how insurance agents are compensated and how this might influence their recommendations Discuss when insurance coverage should be reviewed

Who Should Buy Life Insurance Anyone and everyone who has dependents counting on financial support from the income that the insured would earn. Dependents might include: Minor children Non working spouse Parents who are being supported

Who Should NOT Buy Life Insurance People with no dependents Examples might include: DINKs where each could live on their own income Children Retirees Non working spouses

Policy Owner vs. Insured Policy Owner Pays the premium Controls the policy (e.g., can change the beneficiary, cash it in) Insured Person whose life is covered If not same as policy owner, must give permission to policy owner for the policy

Term Insurance (1 of 2) Good for a fixed time period only Similar to auto insurance (if have no claim, then at end of term have nothing more than cancelled checks) Always the cheapest premium per $1,000 of coverage

Term Insurance (2 of 2) Large variety of term policies 1-year, 5-year, 10- year, 20-year To age 65, to age 90 Decreasing Term (Mortgage insurance)

Cash Value Policy (1 of 2) May be for the life of the insured A cash value associated with the policy, so that if policy cancelled, the cash value belongs to the policy owner Can usually borrow against the cash value

Cash Value Policy (2 of 2) Large variety of cash value policies Whole life Modified Premium or Graded Limited Pay Single Premium Endowment Variable Life Universal Life Variable Universal Life

Borrowing Against a Cash Value Policy (1 of 2) Policy usually has a stated rate for policy loans Maximum loan usually up to 95% of current cash value No fixed repayment schedule Deduct from death benefit if insured dies with loan outstanding

Borrowing Against a Cash Value Policy (2 of 2) Drawbacks to policy loan Reduction in death benefit Advantages of policy loan Potential investment arbitrage Give money to beneficiary now Death benefit need may be lower Enjoy some of money while insured still alive

Participating Policies Company pays a dividend to the policy owner Dividends are tax free as considered rebate of premium Dividends make projecting the true cost of a policy a best guess effort

Riders An attachment to a standard policy Could be free or might require an extra premium Common riders include: Conversion Feature Double Indemnity Disability Waiver Accelerated Death Benefits

Viatical Settlements Policy owner sells an existing policy to a third party Similar to an accelerated death benefit Usually substantial discounts to face value (even if insured terminally ill) May be only way to raise cash while insured still alive

Buying Term & Investing the Difference (1 of 3) True implementation requires: Buy same death benefit as with W.L. Note the difference in premiums Each year, invest the difference in premiums Use the value of the investment to reduce the death benefit when the term policy comes up for renewal

Buying Term & Investing the Difference (2 of 3) Pros of this strategy With reasonable rates of return, will have a larger estate at time of death if make all investments on schedule Even if don’t follow this strategy, then enjoy spending the premium difference while still alive

Buying Term & Investing the Difference (3 of 3) Cons of this strategy If fail to save premiums, then term premiums become prohibitive later in life May not be able to renew term Most people don’t actually save premium differences

How much life insurance should a person have? appropriate size premium approach human life value approach multiple of earnings approach needs approach

Appropriate Size Premium Determine the maximum premium a policy owner is willing to pay Buy as much insurance as this premium will allow Rules of thumb are 5 to 10 percent of family budget

Human Life Value Starts with estimates of future wage income of the insured Reduces this by portion spent on the insured Remainder is discounted The sum of present value is the human life value

Multiple of Earnings Assumes that the ratio of human life value to current wage rate is approximately the same for people with similar incomes and ages Thus, one determines these ratios and constructs a look-up table for the various combinations of age and income

Needs (1 of 3) Most complex of the four approaches Based on what expenses the survivors would face if the insured were to die Easy to be emotional in deciding what one wants their survivors to have if they die, thus could lead to an overstatement of insurance needs

Needs (2 of 3) Four parts to calculation Immediate cash needs at time of death Financial and legal expenses Outstanding bills “Final expenses” Project annual income for survivors and subtract estimated annual expenses

Needs (3 of 3) Take the present value of the differences Sum the present values and subtract current insurance coverage and other financial resources that are available

Which is the best approach? Appropriate size premium: not relevant Human life value: Maximum coverage Multiple of Earnings: usable if can’t use a better approach Needs: Maximum coverage Suggested approach: Lesser of HLV & Needs (one should never be worth more dead than alive)

Should a survivor pay off a mortgage? Paying off a mortgage is equivalent to investing the money risk-free at the mortgage rate Not a good idea if it could be invested at a better (risk-adjusted) rate elsewhere Not a good idea if have liquidity problems

Setting your premium Starts with life expectancy based on the actuarial table (same for all companies) Each insurer then applies own standards to determine the likelihood you will survive. These include: Medical exam Smoking history Hobbies (e.g., skydiving) Profession (e.g., policeman)

How insurance agents are compensated Most of compensation is a large percentage of the first year’s premium Remainder of compensation is a small percentage of each year’s premium thereafter => Like to sell policies with large premiums, and like to upgrade policies

When to review coverage A review is appropriate primarily when there is a major change in one’s personal situation. These include: Birth or death of a child (even better, when plans are made to have a child) A child leaving home Marriage, divorce, death of a spouse Significant change in income