Class 11 Insurance and Risk Management

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Class 11Insurance and RiskManagement

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

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Tax Advantages of Retirement Plans

• A qualified plan receives tax advantages
• Main tax features
• Contributions are not taxable as personal income
  until the benefits are received
• Earnings on assets are not taxed until they are
  received
• Together gtemployee can earn the before-tax rate
  of return in a qualified plan

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Comparing Different Methods of Saving

• Consider amount received after-tax
• from investing 1 of before-tax wages
• for T years
• in an account that earns r percent annually
• for a person with a constant tax rate t
• Outside of a qualified plan (1-t) 1 r(1-t)T
• In a tax deferred account (1-t)(1r)T - t(1r)T
  -1
• (investment earnings are not tax as earned)
• In a qualified plan (1-t)(1 r)T

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Comparing Different Methods of Saving
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Exhibit 14.1 Power of Tax-Deferred Growth
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Individual Annuities

• An annuity is a periodic payment that continues
  for a fixed period or for the duration of a
  designated life or lives
• The person who receives the payments is the
  annuitant
• An annuity provides protection against the risk
  of excessive longevity
• The fundamental purpose of an annuity is to
  provide a lifetime income that cannot be outlived

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Individual Annuities

• Large and growing part of life insurance business
• The major types of annuities sold today include
• Fixed annuity
• Variable annuity
• Equity-indexed annuity

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Uses of Annuities

• Risk management perspective
• Tax advantaged method of saving - Implicit
  returns are tax deferred
• Savings perspective
• Protection against outliving resources

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Annuity Vs. Life Insurance

• Life Insurance
• Creates an immediate estate
• Protects against dying too soon
• Annuity
• Provides a lifetime income that cannot be
  outlived
• Protects against living too long

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Types of Annuities

• Fixed
• Variable
• Equity-indexed

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Fixed Annuities

• A fixed annuity pays periodic income payments
  that are guaranteed and fixed in amount
• During the accumulation period prior to
  retirement, premiums are credited with interest
• The guaranteed rate is the minimum interest rate
  that will be credited to the fixed annuity
• The current rate is based on current market
  conditions, and is guaranteed only for a limited
  period
• A bonus annuity pays a higher interest rate
  initially
• The liquidation period is the period in which
  funds are paid out, or annuitized

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Fixed Annuities

• Fixed annuity income payments can be paid
  immediately, or at a future date
• An immediate annuity is one where the first
  payment is due one payment interval from the date
  of purchase
• Provides a guaranteed lifetime income that cannot
  be outlived
• A deferred annuity provides income payments at
  some future date
• A deferred annuity purchase with a lump sum is
  called a single-premium deferred annuity
• A flexible-premium annuity allows the owner to
  vary the premium payments

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Fixed Annuity Contract Structure

• Contract period is divided in two
• Accumulation period
• Policyholder pays premiums
• Payout period (liquidation period)
• Insurer makes payments

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Fixed Annuity Accumulation Period

• Premiums credited with interest
• Guaranteed minimum rate
• In some states, recently indexed to 5-year
  Treasury bond
• Current rate

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Fixed Annuity Liquidation Period

• This is the payout period
• Accumulated cash is annuitized
• Guaranteed lifetime income
• No protection against inflation

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Payment of Benefits

• Immediate annuity
• Deferred annuity

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Deferred Annuity Premium methods

• Single premium
• Level premium
• Flexible premium

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Fixed Annuities Settlement Options

• The annuity owner has a choice of annuity
  settlement offers
• Most annuities are not annuitized
• Under the cash option, the funds can be withdrawn
  in a lump sum or in installments
• A life annuity option provides a life income to
  the annuitant only while the annuitant remains
  alive
• A life annuity with guaranteed payments pays a
  life income to the annuitant with a certain
  number of guaranteed payments

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Fixed Annuities Settlement Options

• An installment refund option pays a life income
  to the annuitant
• If the annuitant dies before receiving the total
  income payments, the payments continue to a
  beneficiary
• A cash refund option is similar, but pays the
  beneficiary a lump sum
• A joint-and-survivor annuity pays benefits based
  on the lives of two or more annuitants. The
  annuity income is paid until the last annuitant
  dies
• An inflation-indexed annuity option provides
  periodic payments that are adjusted for inflation

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Exhibit 14.2 Examples of Monthly Income Annuity
Payments from an Immediate Annuity, 250,000
Purchase Price, Male, Age 67
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Variable Annuities

• A variable annuity pays a lifetime income, but
  the income payments vary depending on common
  stock prices
• The purpose is to provide an inflation hedge by
  maintaining the real purchasing power of the
  payments
• Premiums are used to purchase accumulation units
  during the period prior to retirement
• The value of an accumulation unit depends on
  common stock prices at the time of purchase
• At retirement, the accumulation units are
  converted into annuity units
• The number of annuity units remains constant
  during the liquidation period, but the value of
  each unit changes with common stock prices
• As a result, amount of monthly income changes
  periodically based on the value of the
  subaccount.

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Variable Annuity Key Point

• Premiums used to purchase accumulation units,
  which are invested in common stocks and other
  investments
• Accumulation units are converted to annuity units
  at retirement.
• In both cases, value of units varies with market

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Variable Annuities

• A guaranteed death benefit protects the principal
  against loss due to market declines
• Typically, if the annuitant dies before
  retirement, the amount paid to the beneficiary
  will be the higher of two amounts the amount
  invested in the contract or the value of the
  account at the time of death
• Some variable annuities pay enhanced death
  benefits
• Some contracts guarantee the principal plus
  income
• Some contracts periodically adjust the value of
  the account to lock in investment gains. Examples
  include
• A rising floor death benefit
• A stepped up benefit
• An enhanced earning benefit

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Variable Annuities

• Variable annuities contain the following fees and
  expenses
• Investment management charge, for brokerage
  services
• Administrative charge, for paperwork, etc.
• Mortality and expense risk charge, to pay for
• The mortality risk associated with the death
  benefit
• A guarantee on the maximum annual expenses
• An allowance for profit
• Surrender charge, if annuity is surrendered in
  the early years of the contract
• Total fees and expenses in most variable
  annuities are high
• Total fees and expenses could exceed 2 of assets

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Variable Annuity Front-end Load

• Some variable annuities may have front-end load
• A front-end load is a commission or sales charge
  applied at the time of the initial purchase for
  an investment, usually mutual funds and insurance
  policies.
• It is deducted from the investment amount and, as
  a result, it lowers the size of the investment.

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Variable Annuity Investment Performance

• Owner given investment choices, similar to mutual
  funds
• Portfolios called sub-accounts
• Funds can be transferred without tax consequences
• Investment performance varies widely depending
  on
• Insurer
• Type of investment
• Expense rate

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Variable Annuity Guaranteed Death Benefit

• If annuitant dies before retirement, amount paid
  to beneficiary will be higher of
• Amount invested in contract
• Value of account at time of death
• Some newer variable annuities offer enhanced
  death benefits
• Rising floor
• Stepped up benefits
• Enhanced earning benefit

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Equity-Indexed Annuities

• An equity-indexed annuity is a fixed, deferred
  annuity that
• allows the owner to participate in the growth of
  the stock market
• A cap specifies the maximum percentage of gain
  that is credited to the contract
• provides downside protection against the loss of
  principal and prior interest earnings if the
  annuity is held to term
• The participation rate is the percent of increase
  in the stock index that is credited to the
  contract
• Insurers use different indexing methods to credit
  excess interest to the annuity
• Equity-indexed annuities with terms longer than
  one year have a guaranteed minimum value

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Purpose Equity-indexed Annuity

• Allows annuity owner to participate in the growth
  of the stock market
• Also provides downside protection against the
  loss of principal and prior interest earnings if
  the annuity is held to term.
• The interest credited is based on a stock market
  index, typically Standard and Poors 500
  Composite Stock Index (SP 500).
• The annuity is credited with part of the gain in
  the index.
• A few insurers have participation rates of 100
  percent.

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Equity Indexed Annuity

• Participation rate Percent of stock index that
  is credited to the contract
• Participation rates generally range from 25
  percent to 90 percent of the gain in the stock
  index.
• Cap on the maximum percentage of gain
• Maximum percentage of gain that is credited to
  the contract

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Equity Indexed Annuity Indexing Method

• Method for crediting excess interest to contract
• Several methods used
• Annual reset method
• Interest earnings calculated changed on annual
  change in stock market
• Index starting point is reset annually
• Also called ratchet method

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Equity-Index Annuity Guaranteed Minimum Value

• Applies to E-A annuities with terms greater than
  one year
• Protects loss of principal if held to term
• Typical minimum value 90 of single value
  accumulated at 3 interest
• During first 3 4 years, investor may experience
  loss of principal

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Taxation of Individual Annuities

• An individual annuity purchased from a commercial
  insurer is a non-qualified annuity
• It does not meet IRS code requirements
• It does not quality for most income tax benefits
• Premiums are not tax deductible
• Investment income is tax deferred
• The net cost of annuity payments is recovered
  income-tax free over the payment period, but the
  amount that exceeds the net cost is taxable as
  ordinary income

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Taxation of Individual Annuities

• An exclusion ratio is used to determine the
  taxable and nontaxable portions of the payments
• Annuities can be attractive to investors who have
  made maximum contributions to other
  tax-advantaged plans

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Taxation of Individual Annuities

• Premiums are not income-tax deductible
• Investment income is tax-deferred
• Accumulates free of taxes until distributed
• Premature distribution (before 59 ½) subject to
  10 penalty tax

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Taxation of Individual Annuities (cont.)

• Net cost of periodic annuity payment not subject
  to taxation
• Exclusion ratio determines taxable and
  non-taxable portions
• Exclusion Ratio Investment in Contract/Expected
  Return
• Example, p.297 of text

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Exhibit 14.4 How Long the Money Will Last (in
years)
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Insight 14.3 Retirement Income Calculator
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Individual Retirement Accounts

• An individual retirement account (IRA) allows
  workers with taxable compensation to make annual
  contributions to a retirement plan up to certain
  limits and receive favorable income-tax treatment
• Two basic types of IRAs are
• Traditional IRA
• Roth IRA

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Traditional IRA Key Concepts

• Eligibility requirements
• Annual contribution limits
• Income tax deduction of traditional IRA
  contributions
• Special phase-out rule for spouses

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Traditional IRA Key concepts

• Withdrawal of funds
• Taxation of distributions
• Establishing a traditional IRA
• IRA investments
• IRA rollover account

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Traditional IRA

• A traditional IRA allows workers to take a tax
  deduction for part or all of their IRA
  contributions
• The investment income accumulates income-tax free
  on a tax-deferred basis
• Distributions are taxed as ordinary income
• The participant must have earned income during
  the year, and must be under age 70½
• A full deduction for IRA contributions is allowed
  if
• The worker is not an active participant in an
  employers retirement plan, or
• The workers modified adjusted gross income is
  below certain thresholds

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Traditional IRA Annual Contribution Limits

• For 2007, the maximum annual contribution is
  4000 or 100 percent of earned compensation,
  whichever is less
• Workers over 50 can contribute up to 5000
• For 2008, the maximum annual contribution is
  5000 or 100 percent of earned compensation,
  whichever is less
• Workers over 50 can contribute up to 6000

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Traditional IRA - Tax Deductibility

• For 2007, full deductibility of a traditional IRA
  contribution was available to active participants
  whose 2007 Modified Adjusted Gross Income (MAGI)
  was
• 50,000 or less for single taxpayers
• 80,000 or less married taxpayers filing a joint
  return.
• The full IRA tax deduction is gradually phased
  out as a persons modified gross income
  increases. In 2007, partial tax deductibility was
  available to
• Single taxpayers with MAGI between 50,000 and
  60,000
• Married taxpayers filing a joint return with MAGI
  between 80,000 and 100,000

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Traditional IRA Spousal Tax Deductibility

• A special phase-out rule applies to married
  couples in situations where one spouse is not an
  active participant in an employer-sponsored
  retirement plan, but the other spouse is an
  active participant.
• Thus, many spouses can make a fully deductible
  contribution to a traditional IRA even though the
  other spouse is covered under a retirement plan
  at work.
• For 2006, eligibility for a full deduction is
  limited to married couples with modified adjusted
  gross incomes of 150,000 or less.
• The deduction is phased out for married couples
  with modified adjusted gross incomes between
  150,000 and 160,000.
• The income limits are indexed for inflation.

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Traditional IRA

• Taxpayers with incomes that exceed the phase-out
  limits can contribute to a nondeductible IRA

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Traditional IRA - Distribution

• Distributions from a traditional IRA before age
  59½ are considered premature, and subject to a
  10 tax penalty, unless certain conditions apply,
  for example
• death or disability
• qualified higher education expenses
• qualified first home purchase (lifetime limit of
  10,000)
• unreimbursed medical expenses in excess of 71/2
  of adjusted gross income
• Payment of health insurance premiums for a worker
  separated from employment
• substantially equal periodic payments.
• Distributions from traditional IRAs are treated
  as ordinary income
• Any nondeductible contributions are received
  income-tax free
• A formula is used to compute the taxable and
  nontaxable portions of each distribution

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Establishing a Traditional IRA

• Traditional IRAs can be established at a bank,
  mutual fund, stock brokerage firm, or insurer
• The IRA can be set up as either
• An individual retirement account
• An individual retirement annuity
• IRA contributions can be invested in a variety of
  investments
• An IRA rollover account is an account established
  with funds distributed from another retirement
  plan

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Roth IRA

• A Roth IRA is another type of IRA that provides
  substantial tax advantages
• The annual contributions to a Roth IRA are not
  tax deductible
• The investment income accumulates income-tax free
• Qualified distributions are not taxable under
  certain conditions
• Contributions can be made after age 70½
• Roth IRAs have generous income limits
• A traditional IRA can be converted to a Roth IRA

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Roth IRA

• Income limits
• Single taxpayers 95,000 or less
• Married filing jointly 150,000 or less
• Conversion to a Roth IRA
• Limited to taxpayers with adjusted gross income
  of 100,000 or less

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Roth IRA Income Limits

• For single filers - up to 99,000 for 2007 and
  101,000 for 2008 (99,000-114,000 in 2007 and
  101,000-116,000 for a partial contribution in
  2008).
• For joint filers - up to 156,000 for 2007 and
  159,000 for 2008 (156,000-166,000 in 2007 and
  159,000-169,000 in 2008 for a partial
  contribution in 2008).

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Roth IRA

• What is the maximum annual contribution?
• For 2007, 4,000 and for 2008, 5,000, or 100 of
  employment compensation, whichever is less.

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Roth IRA

• What is the amount for catch-up contributions?
• Individuals age 50 or older (in the calendar year
  of their contribution) can contribute an
  additional 1,000.

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Roth IRA Withdrawals

• Roth IRA contributions can always be withdrawn at
  any time without penalty.
• For Roth earnings, penalty-free withdrawals
  include but are not limited to
• qualified higher education expenses
• qualified first home purchase (lifetime limit of
  10,000)
• certain major medical expenses
• certain long-term unemployment expenses
• disability
• substantially equal periodic payments.

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Roth IRA Tax Treatment

• Annual contributions to a Roth IRA are not
  income-tax deductible.
• Investment income accumulates income-tax free
• Qualified distributions are not taxable if
  certain requirements are met.

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Roth IRA Tax Treatment

• A qualified distribution is any distribution that
  is made
• After a five-year period beginning with the first
  tax year for which a Roth contribution is made
• For any of the following reasons
• The individual is age 59 1/2 or older.
• The individual is disabled.
• Distribution is paid to a beneficiary or to the
  estate after the individuals death.
• Distribution is used to pay qualified first-time
  homebuyer expenses (maximum of 10,000).

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Traditional IRA vs. Roth IRA

• What are the federal tax advantages?
• Traditional Tax-deferred growth.
• Roth Tax-free growth.
• Is there a mandatory withdrawal age?
• Traditional Yes, distributions must start at age
  70½.
• Roth No
• What is the maximum annual contribution?
• Both Traditional and Roth
• For 2007, 4,000 or 100 of employment
  compensation, whichever is less
• For 2008, 5,000, or 100 of employment
  compensation, whichever is less
• What is the amount for catch-up contributions?
• Both Traditional and Roth
• Individuals age 50 or older (in the calendar year
  of their contribution) can contribute an
  additional 1,000.

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Health Care Problems in the US

• Problem 1 Rising Health Care Expenditures
• Health care expenditures in the US have increased
  substantially over time and are outstripping the
  growth in the economy
• Group health insurance premiums are rising faster
  than the rate of inflation
• Factors affecting health care costs include
• Rising outpatient and inpatient costs
• Rising cost of prescription drugs
• Rising cost of physician services

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Exhibit 15.1 Increases in Health Insurance
Premiums Compared to Other Indicators, 19882005
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Health Care Problems in the US

• Problem 2 Many people do not have health
  insurance coverage
• Groups with large number of uninsured include
• Foreign born
• Hispanics, Blacks, and Asians
• Young adults
• Low income households
• Many people are uninsured because the coverage is
  not affordable
• Some people are denied coverage, or do not
  believe health insurance is needed
• Many low income people who are eligible for
  Medicaid are not aware they are eligible

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Exhibit 15.2 Reasons for Not Having Health
Insurance
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Health Care Problems in the US

• Problem 3 Uneven Quality of Medical Care
• The quality of medical care varies widely
• There is a quality gap in the US many people
  do not receive the most effective care
• Many doctors are not following the recommended
  guidelines in treating common ailments
• Problem 4 Waste and Inefficiency
• The administrative costs of delivering health
  insurance benefits are excessively high