1. Chapter 13 (18): Life Insurance Purchase Decisions
Determining the Cost of Life Insurance
Rate of Return on Saving Component
Taxation of Life Insurance
Shopping for Life Insurance

2. Determining the Cost of Life Insurance
The cost of a life insurance policy is the difference between what you pay and what you get back
When determining the cost of life insurance, four major factors must be considered:
Annual premiums
Cash values
Dividends
Time value of money

3. Determining the Cost of Life Insurance
Under the traditional net cost method, the cash value and expected dividends are subtracted from annual premiums to obtain a net cost per year figure
This method does not consider the time value of money

4. Exhibit 13.1 Traditional Net Cost Method
Female, aged 20, $10,000 ordinary whole life, annual premium = $132.1.

5. Determining the Cost of Life Insurance
The interest-adjusted cost method is more accurate because it considers the time value of money
Interest-adjusted cost indices come in two forms:
The surrender cost index is useful if the owner expects to surrender the policy after some time period
The net payment cost index is useful if the owner expects to keep the policy in force

6. Exhibit 13.2 Surrender Cost Index
Female, aged 20, $10,000 ordinary whole life, annual premium = $132.1.

7. Exhibit 13.3 Net Payment Cost Index
Female, aged 20, $10,000 ordinary whole life, annual premium = $132.1.

8. Determining the Cost of Life Insurance
Interest-adjusted cost indices can be used to compare policies across insurers
There is a wide variation in costs indices across insurers – it pays to shop around!
Most consumers use premiums as a basis for comparison, but agents will supply cost indices

9. Comparison of Interest-Adjusted Costs for Selected Companies

10. Exhibit Whole Life Actual Historical Performance $250,000 Male Nonsmoker Preferred Class, Age 45

11. Exhibit 18.4 (11e) Whole Life Actual Historical Performance $250,000 Male Nonsmoker Preferred Class, Age 45 Policy Issued 12/31/1988. Last Day 12/31/2008. 11

12. Determining the Cost of Life Insurance
The Life Insurance Policy Illustration Model Act requires insurers to present certain information to applicants for life insurance
The goal is to reduce misunderstanding of policy values by policyowners, and reduce deceptive sales practices by agents
A narrative summary describes the basic characteristics of the policy
A numeric summary shows the premium outlay, value of the accumulation account, cash surrender values and death benefit
The act also prohibits certain sales practices and requires the insurer to provide an annual report

13. Rate of Return on Saving Component
The annual rate of return earned on the savings component of a policy is an important consideration if you intend to invest over a long period of time
The Linton yield is the average annual rate of return on a cash value policy if it is held for a specified number of years

14. – Consumer Federation of America
Exhibit 18.5 (11e) Average Annual Rates of Return for 109 Cash-Value Policies by Year of Policy
Consumers should not purchase a cash-value policy unless they plan to hold it for at least 20 years.
– Consumer Federation of America

15. Rate of Return on Saving Component
The yearly rate of return method is based on a formula:
The information needed for the calculation is readily available to consumers

16. Yearly Rate of Return Method
Mark, (42), purchased $100,000 par-policy at (35), premium =$1,500 p.a.
CV8 = 9200; D8 = 400; CV7 = 7800.
YRT8 = 4 ‰

17. Exhibit 13.5 Benchmark Prices

18. Taxation of Life Insurance
Life insurance proceeds paid in a lump sum to a designated beneficiary are generally received income-tax free
The interest component of periodic payments is taxable as ordinary income
Premiums are generally not deductible
Dividends are not taxable, but interest on dividends retained is taxable
If a policy is surrendered for its cash value, any gain is taxable as ordinary income

19. Taxation of Life Insurance
Proceeds from a life insurance policy are included in the gross estate of the insured for federal estate-tax purposes if:
the insured has any ownership interest
they are payable to the estate
The proceeds may be removed from the gross estate if the policyowner makes an absolute assignment of the policy to someone else
The policyowner must make the assignment more than three years before death

20. Taxation of Life Insurance
A federal estate tax is payable if the decedent's taxable estate exceeds certain limits
A tentative tax on the taxable estate value is calculated
The gross estate includes property you own, one-half of the value of property owned jointly with your spouse, life insurance death proceeds in which you have ownership interest
The gross estate may be reduced by certain deductions, such as a marital deduction, in determining the taxable estate
The taxable estate may be reduced or eliminated by a tax credit called a unified credit
The amount of property exempt from taxation will increase in the future
$5.12M in 2012; $5.34M in 2014; $5.45M in 2016

21. Exhibit 13.6 Calculating Federal Estate Taxes*21

22. Exhibit 13.7 Shopping For Life Insurance

23. Exhibit 13.8 Rating Categories for Major Rating Agencies

25. Premium Calculations in Life Insurance
The net single premium (NSP) is defined as the present value of the future death benefit
The NSP is based on three assumptions:
Premiums are paid at the beginning of the policy year
Death claims are paid at the end of the policy year
The death rate is uniform throughout the year

26. Calculating the Net Single Premium for Term Insurance
For yearly renewable term insurance, the cost of each year’s insurance is easily determined:

27. Exhibit 13A.1 Commissioners 2001 Standard Ordinary (CSO) Table of Mortality, Male Lives (selected ages)

28. Exhibit 13A.2 Present Value of $1 at 5.5% compound interest

29. Calculating the Net Single Premium for Term Insurance
For a five-year term policy, the cost of each year’s mortality must be computed separately for each of the five years and then added together to determine the NSP

30. Exhibit 13A.3 Calculating the NSP for a Five-Year Term Insurance Policy, Male, Age 32

31. Calculating the Net Single Premium for Ordinary Life Insurance
For an ordinary life insurance policy, the cost of each year’s mortality must be computed separately for each year to the end of the mortality table, and then added together to determine the NSP

32. Calculating the Net Annual Level Premium
The net annual level premium is calculated using a formula:
If premiums are paid for life, the premium is called a whole life annuity due
If premiums are paid for only a temporary period, the premium is called a temporary life annuity due

33. Policy Reserves
Under the level-premium method for paying premiums, premiums paid during early years are higher than necessary to pay death claims
The excess premiums are reflected in the policy reserve
Policy reserves are a liability item on the insurer’s balance sheet that must be offset by assets equal to that amount
The policy reserve is the difference between the PV of future benefits and the PV of future net premiums
The policy reserve has two purposes:
It is a formal recognition of the insurer’s obligation to pay future claims
It is a legal test of the insurer’s solvency

34. Exhibit 13A.4 Prospective Reserve — Ordinary Life Insurance (1980 CSO mortality table)

35. Policy Reserves
The retrospective reserve represents the net premiums collected by the insurer for a particular block of policies, plus interest earnings at an assumed rate, less the amounts paid out as death claims
The prospective reserve is the difference between the present value of future benefits and the present value of future net premiums
Both methods will produce the same level of reserves at the end of any given year under the same actuarial assumptions

36. Policy Reserves
A terminal reserve is the reserve at the end of any given policy year
The initial reserve is the reserve at the beginning of any policy year
The mean reserve is the average of the terminal and initial reserves. It is used to indicate the insurer’s reserve liabilities on its annual statement

37. Case Application & Bonus Question #3
NSP = $4.88 and NALP=$1.09
Bonus Question#3 (Due next class meeting): If you have a life insurance story to share, a bonus credit is possible.