Class 7 Insurance and Risk Management

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Class 7Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Winter 2008

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Agenda

• Review
• Types of Life Insurance
• Life Insurance Contractual Provisions
• Taxation of Life Insurance
• Calculation of Life Insurance Premiums
• Introduction to the Personal Auto Policy

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Exhibit 11.6 Comparison of Major Life Insurance
Contracts
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Exhibit 11.4 Two forms of Universal Life
Insurance Death Benefits
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Life Insurance Contractual Provisions

• Ownership Clause
• Entire Contract Clause
• Incontestable Clause
• Suicide Clause
• Grace Period
• Reinstatement Clause

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Life Insurance Contractual Provisions (cont.)

• Misstatement of Age Clause
• Beneficiary Designation
• Change of Plan Provision
• Exclusions and Restrictions
• Assignment Clause
• Policy Loan Provision
• Automatic Premium Loan

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Change of Plan Provision

• Purpose Provide flexibility to policyowner to
  respond to changing needs for insurance
• Allows exchange of present policy for different
  contract

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Change of Plan Provision Rules

• Change to higher-premium policy
• Policyowner pays difference in policy reserve of
  new policy versus original contract
• No evidence of insurability required

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Change of Plan Provision Rules

• Change to lower-premium policy
• Insurer refunds difference in cash values
• Evidence of insurability is required
• Reduced cash value increases insurers net amount
  at risk
• Lower premium policy provides higher pure
  insurance protection

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Exclusions and Restrictions

• Suicide clause
• First two years only (most contracts)
• Whole Life Policy in Appendix C has one-year
  suicide clause (See p. 681)
• War clause
• Excludes payment if insured dies as a direct
  result of war
• Purpose To reduce adverse selection
• Not contained in all policies

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Exclusions and Restrictions (cont.)

• Aviation exclusion variations
• Exclude aviation deaths other than as fare-paying
  passenger on regularly schedule airline
• Exclude military aviation or cover at additional
  premium only
• Exclude private pilot not meeting certain flight
  standards, or charge higher premium

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Exclusions and Restrictions (cont.)

• Hazardous activities may be discovered in initial
  underwriting
• Auto racing
• Scuba diving
• Hang-gliding
• Travel or residence in a dangerous country
• Underwriter may exclude or cover only with
  payment of extra premium

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Payment of Premium

• Payment modes Annual, semi-annual, quarterly or
  monthly
• Carrying charge is relatively expensive
• Example p.249
• Annual premium 1,000
• Semiannual premium 520
• Apparent charge 4 40/1000
• Effective carrying charge
• 16.7 40/(1000-520) x 2

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Assignment Clause

• Life Insurance policy is freely assignable
• Two types of assignment
• Absolute assignment
• Collateral assignment

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Absolute Assignment

• All ownership rights are transferred to a new
  owner
• Church
• Charity
• Educational Institution
• Insured
• Beneficiary
• New owner receives all ownership rights in the
  policy

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Collateral Assignment

• Policyowner assigns policy as collateral for a
  loan
• Previously, American Bankers Association
  assignment form was typically used.
• Now, insurers generally use their own collateral
  assignment forms.
• Collateral assignment confers limited rights in
  the policy
• Assignee entitled to receive death proceeds only
  to extent of loan
• Balance of proceeds are paid to beneficiary

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Impact of Assignment Clause

• If Insurer is notified of assignment,
• A new contract exists between insurer and
  assignee
• Insurer recognizes assignees rights as superior
  to beneficiarys rights
• If Insurer is not notified of assignment,
• Proceeds are paid to named beneficiary
• Insurer is relieved of any further obligation
• Even if a valid assignment is in existence

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Policy Loan Provision

• Allows policyowner to borrow the cash value
• The policyowner must pay interest on the loan to
  offset the loss of interest to the insurer
• A policy could lapse if the policyowner does not
  repay a loan and the total indebtedness exceeds
  the available cash value
• Advantages
• Low annual percentage rate
• No paperwork, no credit check
• Flexibility in repaying, no fixed repayment
  schedule
• Disadvantages
• Heavy borrowing may cause policy to lapse
• Amount of protection is reduced

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Automatic Premium Loan

• Under the automatic premium loan provision, an
  overdue premium is automatically borrowed from
  the cash value after the grace period expires
• Purposeto prevent the policy from lapsing
• Main disadvantages
• Policyowner may become lazy and exhaust some or
  all of the cash values
• If cash values are reduced, amount of protection
  is reduced
• If cash values become exhausted, policy will lapse

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Use of a Trust

• Alternative to Settlement Option
• Desirable when
• Amount of insurance is substantial
• Judgment in amount and timing of pay-outs is
  required
• Example situations
• Minor children
• Mentally handicapped adult
• Disadvantages
• Must pay trustees fee
• Returns not guaranteed

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Additional Life Insurance Benefits

• Other benefits can be added to a life insurance
  policy for an additional premium
• Waiver-of-Premium
• Guaranteed Purchase Option
• Double Indemnity Rider
• Cost-of-Living Rider
• Accelerated Death Benefits Rider

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Waiver of Premium Provision

• If the insured becomes totally disabled, all
  premiums coming due during the period of
  disability are waived.
• In many current waiver-of-premium provisions,
  total disability means that
• Because of disease or bodily injury, the insured
  cannot do any of the essential duties of his or
  her job, or of any job for which he or she is
  suited based on schooling, training, or
  experience.
• If the insured can perform some but not all of
  these acts and duties, the disability is not
  considered to be total, and premiums will not be
  waived.
• If the insured is a minor and is going to school,
  premiums are waived if the minor is unable to go
  to school.

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Waiver of Premium Provision

• Another definition of total disability found in
  some policies is more liberal.
• Total disability is initially defined in terms of
  your own occupation.
• For the first two years, total disability means
  the insured cannot work in the occupation that he
  or she had at the time the disability occurred.
• After the initial period expires, the definition
  becomes stricter. The insured is considered
  totally disabled only if he or she cannot work in
  an occupation for which he or she is qualified by
  education, training, and experience.

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Guaranteed Purchase Option

• Permits the policyowner to purchase additional
  amounts of life insurance at specified times in
  the future without evidence of insurability, up
  to some maximum age
• The option guarantees the purchase of specified
  amounts of life insurance in the future even
  though the insured may become uninsurable
• Example (p.260 of text) The guaranteed purchase
  option allows additional purchases of life
  insurance when the insured attains the ages of
  25, 28, 31, 34, 37, 40, 43 and 46.
• Amount is limited to face amount of basic policy
  in this case, 25,000
• Total amount of additional insurance that can be
  purchased without evidence of insurability
  200,000

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Additional Life Insurance Benefits

• The accidental death benefit rider doubles the
  face amount of life insurance if death occurs as
  a result of an accident
• Also known as double indemnity
• The cost-of-living rider allows the policyowner
  to purchase one-year term insurance equal to the
  percentage change in the consumer price index
  with no evidence of insurability
• The accelerated death benefits rider allows
  insureds who are terminally ill to collect part
  or all of their life insurance benefits before
  they die
• Forms include a terminal illness rider,
  catastrophic illness rider, and long-term care
  rider

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Additional Life Insurance Benefits

• A viatical settlement is the sale of a life
  insurance policy by a terminally ill insured to
  another party, typically an investor group, who
  hopes to profit by the insureds early death
• A life settlement is the sale of a life insurance
  policy by a policyowner who no longer needs or
  wants the insurance
• These options create a moral hazard problem, and
  may not be adequately regulated by the states

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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

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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

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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
• Federal estate taxes are scheduled to expire in
  2010
• Tax will be reinstated in 2011 unless Congress
  acts

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Exhibit 13.7 Calculating Federal Estate Taxes
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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

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Calculating the Net Single Premium for Term
Insurance

• For yearly renewable term insurance, the cost of
  each years insurance is easily determined

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Exhibit 13A.1 Commissioners 2001 Standard
Ordinary (CSO) Table of Mortality, Male Lives
(selected ages)
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Calculating the Net Single Premium for Term
Insurance

• For a five-year term policy, the cost of each
  years mortality must be computed separately for
  each of the five years and then added together to
  determine the NSP

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Exhibit 13A.3 Calculating the NSP for a Five-Year
Term Insurance Policy, Male, Age 32
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Calculating the Net Single Premium for Ordinary
Life Insurance

• For an ordinary life insurance policy, the cost
  of each years mortality must be computed
  separately for each year to the end of the
  mortality table, and then added together to
  determine the NSP

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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

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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
  insurers 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 insurers
  obligation to pay future claims
• It is a legal test of the insurers solvency

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Exhibit 13A.4 Prospective Reserve Ordinary Life
Insurance (1980 CSO mortality table)
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Personal Auto Policy

• Part A Liability Coverage
• Part B Medical Payments Coverage
• Part C Uninsured Motorists Coverage
• Part D Coverage for Damage to Your Auto
• Part E Duties After an Accident or Loss
• Part F General Provisions

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Personal Auto Policy Basics

• The 2005 Personal Auto Policy (PAP) is widely
  used throughout the US
• Drafted by the ISO, it replaces the 1998 form
• Eligible vehicles include
• A four-wheeled motor vehicle owned or leased by
  the insured for at least six consecutive months
• A pick-up or van with a gross vehicle weight
  rating of 10,000 pounds or less
• Cannot be used for deliveries, with some
  exceptions

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Personal Auto Policy Basics

• Autos covered by the policy include
• Any auto shown in the declarations
• A newly acquired auto
• Coverage depends on whether it is an additional
  vehicle or a replacement vehicle and whether the
  declarations indicates at least one auto for
  collision coverage
• A trailer owned by the named insured
• A temporary substitute vehicle, which is a
  nonowned auto or trailer used temporarily because
  of mechanical breakdown, repair, servicing, loss,
  or destruction of a covered vehicle

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Part A Liability Coverage

• Liability coverage (Part A) is the most important
  part of the PAP
• It protects a covered person against a suit or
  claim arising out of the ownership or operation
  of a covered vehicle
• The coverage is usually written in split limits,
  where the amounts of insurance for bodily injury
  liability and property damage liability are
  stated separately
• For example, split limits of 250/500/100 mean
  that you have bodily injury coverage of 250,000
  for each person, a maximum of 500,000 of bodily
  injury coverage per accident, and a maximum of
  100,000 for property damage liability
• The insurer also agrees to provide defense and
  pay all legal defense costs for claims covered by
  the policy
• Defense costs are covered in addition to the
  policy limits

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Combined Single Limit

• A single limit applies to both bodily injury and
  property damage.
• The total limit applies to the entire accident.
• There is no separate limit for each person.

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Split Limit Example

• 250,000/500,000/100,000
• 250,000 each person
• 500,000 each accident
• 100,000 for property damage
• Practioners frequently write 250/500/100

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Combined Single Limit Example

• 500,000 CSL
• Single limit of liability applies to both bodily
  injury and property damage.

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Part A Liability Coverage

• In addition to the policy limits and legal
  defense, certain supplementary payments can be
  paid, including
• The cost of a bail bond
• Premiums on appeals bonds
• Interest accruing after a judgment
• Loss of earnings (200/day)
• Other reasonable expenses

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Part A Liability Coverage

• Exclusions to the coverage include
• Intentional injury or damage
• Property owned or transported
• Property rented, used, or in the insureds care
• Bodily injury to an employee
• Use as a public livery or conveyance
• Vehicles used in the auto business
• Vehicles with fewer than four wheels
• Vehicle furnished for the insureds regular use

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Definition of You

• The Named Insured shown in Declarations
• The Spouse of Named Insured if a resident of the
  same household

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Definition of Insured Part A

• You or any resident family member for the
  ownership, maintenance and use of any auto or
  trailer
• Any person using the named insureds covered auto
  
• Any person or organization, but only for
  liability arising out of an insured persons use
  of a covered auto on behalf of that person or
  organization.
• Any person or organization legally responsible
  for the named insureds or family members use of
  any auto or trailer (other than a covered auto or
  one owned by that person or organization)

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Part A Out of State Coverage

• If an accident occurs in another state, and the
  financial responsibility law in that state has
  higher liability limits than shown in the
  declarations, the PAP automatically provides the
  higher limits
• That is, PAP policy automatically adjusts to
  comply with
• Financial responsibility law, or
• No-fault law of another state.

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Part A Other Insurance

• If two auto policies cover a loss to an owned
  automobile, each company pays its pro rata share
  of the loss.
• If the insured is driving someone elses car and
  has an accident, the insureds policy is excess
  and the insurance on the borrowed car is primary.

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Exhibit 22.1 Primary and Excess Insurance
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Part B Medical Payments

• Medical payments coverage covers all reasonable
  medical and funeral expenses incurred by an
  insured in an accident
• Two groups are eligible for coverage
• The named insured and family members are covered
• While occupying any motor vehicle, or
• As pedestrians when struck by a motor vehicle
• Other persons occupying a covered auto are
  covered
• But not covered in a nonowned vehicle
• Covers medical services rendered within three
  years from the date of the accident
• Coverage is not based on fault

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Part B Medical Payments

• Exclusions to the coverage include injuries
  sustained
• While occupying a vehicle with fewer than four
  wheels
• While operating the vehicle as a public livery or
  conveyance
• When the vehicle is used as a residence
• When the vehicle is used without a reasonable
  belief of permission
• When the vehicle is competing in a race
• If more than one auto policy covers a loss
• The insurer pays its pro rata share of the loss
  for an owned vehicle
• The insurance coverage is excess over any other
  insurance for a nonowned vehicle

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Part C Uninsured Motorists Coverage

• The uninsured motorists coverage pays for the
  bodily injury caused by an uninsured motorist, by
  a hit-and-run driver, or by a negligent driver
  whose insurance company is insolvent
• In some states, property damage is also covered
• The uninsured motorist must be legally liable
• The coverage applies to
• The named insured and family members
• Any other person while occupying a covered auto
• Any person legally entitled to recover damages
  (e.g., a surviving spouse)

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Uninsured Motorists Background

• According to the Insurance Research Council, an
  estimated 14.6 of US drivers are uninsured.
• Wide variation among the states
• 26 Mississippi
• 4 Maine

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Part C Uninsured Motorists Coverage

• Pays for bodily injury (and property damage in
  some states) caused by
• An uninsured motorist
• Hit and run driver
• Negligent driver whose insurance company is
  insolvent
• Negligent driver who has insurance, but the
  amount is less than required by the states
  financial responsibility law

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Part C Uninsured Motorists Coverage

• Coverage does not apply when
• An insured is injured in, or by, a vehicle owned
  by the named insured, but not insured under the
  policy
• There is primary coverage under another policy
• The vehicle is used as a public livery or
  conveyance
• Does not apply to a carpool
• When workers compensation benefits are applicable
• There are several limitations when more than one
  uninsured motorist coverage provision applies to
  a loss
• For example, if an insurer provides coverage on a
  vehicle not owned by the named insured, the
  insurance provided is excess over any collectible
  insurance provided on a primary basis

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Part C Uninsured Motorists Coverage

• Underinsured motorists coverage can be added to
  the PAP to provide more complete protection
• In general, the maximum amount paid is the
  underinsured motorists coverage limit stated in
  the policy less the amount paid by the negligent
  drivers insurer
• Coverage is typically added as an endorsement
• Some states make it mandatory, while others make
  it optional