Class 13 Insurance and Risk Management

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Class 13Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2006

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Premature Death - Revisited

• Definition Death of a family head with
  outstanding unfulfilled financial obligations
• The insured event is the uncertainty of the time
  of death

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Economic Justification of Life Insurance

• Economic justification arises when
• The Insured earns an income
• Others are dependent on that income for at least
  part of their financial support

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Premature Deaths Impact on Different Family Types

• Single people
• Single parent
• Two-income earners
• Traditional families
• Blended families
• Sandwiched families

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How Much Life Insurance IS Needed?

• Human Life Value Approach
• Needs Approach
• Capital Retention Approach

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Methods of Providing Life Insurance

• Yearly Renewable Term Method
• Level-Premium Method

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Yearly Renewable Term

• Provides life insurance for one year only.
• Insured may renew for successive one-year
  periods, with no evidence of insurability.

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Cost Yearly Renewable Term

• Pure premium is determined by the mortality rate
  at each attained age.
• Gradual premium increase during the early years.
• Premiums rise sharply in the later years.

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Pure Premium Yearly Renewable Term

• Males
• 1000 face amount

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Level Premium Method

• Premiums do not increase year to year.
• Premiums in early years exceed amount required to
  pay current age death claims.
• Premiums paid in the later years fall far short
  of death claims
• Redundant premiums (plus compound interest) are
  used to supplement inadequate premiums paid
  during the later years.

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Legal Reserve

• Since the redundant premiums will be needed
  later, a legal reserve is required.
• Fundamental purpose of the legal reserve is
  lifetime protection.
• As the legal reserve increases, the net amount at
  risk declines.
• As a result, the cost of insurance is reasonable
  at all ages.

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EXHIBIT 16.3 Relationship Between the Net Amount
at Risk and Legal Reserve
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Cash Values

• Cash values are the by-product of level premium
  method.
• Cash values and the legal reserve are computed
  separately.
• Loading for expenses and high acquisition costs
  cause cash values to be initially below the legal
  reserve

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Summary Level Premium Method

• Fundamental purpose of level premium method is to
  provide life-time protection
• Cash values are the by-product of this method.
• Nevertheless, large amounts are saved annually by
  customers in the form of accumulated cash values
• Saving feature of level premium life insurance is
  incidental to the goal of lifetime protection

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Types of Life Insurance

• Term Insurance
• Cash-value life insurance

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Term Insurance Characteristics

• Temporary period of protection
• Guaranteed renewable
• Age limitation to minimize adverse selection
• Convertible
• No savings element

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Methods of Conversion

• Attained age-method
• Original age-method

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Types of Term Insurance

• Yearly renewable term
• 5, 10, 15, or 20 year-term (or longer)
• Term to age 65

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Decreasing Term

• Face amount gradually declines over policy period
• Premiums remain level
• Some policies structured so that premiums fully
  paid several years before coverage expires

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Reentry Term

• Renewal premiums based on select (lower)
  mortality rates of recently insured lives
• Insured must periodically show good health and
  evidence of insurability

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When Is Term Insurance Is Appropriate?

• Income to purchase life insurance is limited.
• Example p.375
• Male, Age 30 500 a year to purchase life
  insurance
• Purchasing power
• 56,000 of ordinary life insurance
• 500,000 yearly renewable term insurance
• Need for protection is temporary
• To guarantee future insurability

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Term Insurance Limitations

• Premiums increase with age, eventually reaching
  prohibitive levels
• Not suitable for lifetime protection
• No saving component

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Whole Life

• Cash value policy that provides lifetime
  protection
• Higher upfront premiums than term
• Level premium throughout the premium paying
  period
• Two historically significant types
• Ordinary life
• Limited payment life

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Ordinary Life

• Other names straight life and continuous premium
  whole life.
• A claim is a certainty
• Either the Insured dies prior to age 100, or the
  policy endows at age 100

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Ordinary Life (cont.)

• Policyholder prepays part of the cost of future
  death protection
• Excess premiums reflected in the legal reserve
• As a by-product, policyholder builds equity in
  the policy

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Ordinary Life (cont.)

• Equity or savings element is called
• Cash Surrender Value
• Cash surrender value
• Can be obtained by surrendering policy
• Or can be borrowed against under policy loan
  provision

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Ordinary Life (cont.)

• Cash values
• Small or non-existent in early years
• Increase over time
• Example
• Ordinary Life, issued age 20, Male
• At least 50,000 of cash value at 65.
• Ordinary Life, issued age 37, Male
• 41,700 of cash value at age 65.
• P. 693 of text

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Ordinary Life Insurance
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Ordinary Life Uses

• Appropriate when lifetime protection is needed in
  such cases as
• Estate clearance fund
• Federal estate taxes
• Divorce settlement
• Desire to leave a large bequest whenever death
  occurs
• Can also be used to accumulate savings

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Biggest Limitation of Ordinary Life

• Purchase of ordinary life may cause a person to
  be underinsured
• Savings or lifetime protection may not be the
  priority
• Term insurance might be a better choice

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Limited Payment Life Insurance

• Premiums payable only for certain number of
  years
• Examples 10, 20, 30, or to age 65
• Extreme form Single premium whole life
• Permanent insurance - lifetime protection
• Not likely to be suitable for modest income
  people

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Endowment Insurance

• Endowment policy pays face amount if insured dies
  within a specified period
• If the insured survives to the end of endowment
  period, the face amount is paid to the
  policyowner

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Endowment Insurance (cont.)

• Impacted by Deficit Reduction Act of 1984
• New endowment policies no longer meet tax
  definition of life insurance
• Caused most life insurers to discontinue sale of
  new endowment policies

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Endowment Insurance (cont.)

• As a result, endowment policies no longer play a
  significant role
• Now represent less than 1 of total life
  insurance in force
• However, many older endowment policies are still
  in force
• Some are used in tax-qualified retirement plans

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Variations of Whole Life

• Life insurance experienced intense competition
  from other financial products.
• To remain competitive and overcome criticism, new
  products were developed.
• The new products combine insurance protection and
  the savings (investment) component in innovative
  ways.

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Important Variations of Whole Life

• Variable Life Insurance
• Universal Life Insurance
• Variable Universal Life Insurance
• Current Assumption Whole Life Insurance
• Indeterminate Premium Whole Life Insurance

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Variable Life Insurance

• Fixed premium policy
• Death benefit and cash values vary according to
  the investment experience of a separate account
  maintained by the insurer.
• Premiums are invested in equities or other
  investments.
• Cash values are not guaranteed.

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Variable Life Insurance Investment Feature

• Entire policy reserve is held in a separate
  account
• Policy owner has the option to invest the cash
  value in a variety of investments, such as
• Common stock fund
• Bond fund
• Balanced fund
• Money market fund
• international fund

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Variable Life Insurance Cash Surrender Values

• Actual cash values depend on investment
  experience.
• No minimum guaranteed cash values.
• Insurer bears risk of excessive mortality and
  expenses.
• Policy owner bears risk of poor investment results

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Universal Life

• Flexible premium life insurance policy that
  provides protection under a contract that
  unbundles the protection and savings components

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Universal Life

• Similar to whole life
• However, 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

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Characteristics of Universal Life Insurance

• Unbundling of protection, saving, and expense
  components
• Guaranteed minimum interest rate and current
  market interest rate
• Two forms of universal life insurance

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Characteristics of Universal Life Insurance

• Considerable flexibility
• Cash withdrawals permitted
• Favorable income-tax treatment

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Annual disclosure Statement

• Shows
• Premiums paid
• Death Benefit
• Value of cash value account
• Mortality charge
• Expense charges
• Interest credited

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Factors Affecting UL Cash Value
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Death Benefit Options with UL

• Level death benefit (as with WL)
• Death benefit varies with cash value

Death benefit
Death benefit
Cash value
Cash value
age
age
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EXHIBIT 17.2 Universal Life Insurance Death
Benefits
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Variable Universal Life

• Flexible Premiums
• Cash values invested in a wide variety of
  investments
• No minimum guaranteed rate of interest, and cash
  values are not guaranteed.
• Policy has relatively high expense charges.
• Policy has a substantial investment risk.

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Current Assumption Whole Life

• Nonparticipating whole life policy in which the
  cash values are based on the insurers current
  experience with respect to
• Mortality
• Investment income
• Expenses

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Current Assumption Whole Life (cont.)

• Guaranteed minimum cash values
• Higher cash values are based on current interest
  rates.
• Two forms
• Low premium products
• High premium products

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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

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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