chapter 4

Life InsuranceStructure, Concepts, and

Planning Strategies

Chapter 4: Life Insurance 1

CHAPTER 4

There are 3 basic markets in financial services (Byerly)◦Wealthy About 3 – 4% of the population

◦Middle America 25K – 100K household

◦Low income Little need for financial services


Financial Services

Gear marketing efforts at the wealthy◦ Higher profit potential per client◦ Fewer clients◦ Complex financial situations Taxes Estate planning

Focus on Middle America ◦ Many more clients◦ Less profit per client◦ Simpler needs


Business Philosophy (Byerly)

1. Identify the nature and cause of the risk2. Assess probability of loss and amount of potential loss3. Understand weaknesses of the current risk

management plan4. Evaluate alternative methods for handling the risk5. Develop strategy and product recommendations6. Implement the risk management plan7. Monitor the situation


INTRODUCTION TO THE RISK MANAGEMENT PROCESS

Risk Avoidance◦ Simply choose not to do the risky activity

Risk Retention◦ Personally assume the risk

Voluntarily Involuntarily (uninsurable)

Risk Reduction◦ Loss prevention and control

Smoke detectors◦ Spread out the risk

Insurance companies insure millions so the loss from one has little affect

Risk Sharing◦ Through deductibles and using other companies

Risk Transfer◦ Purchase of insurance◦ Hedging with contracts


THEORY OF RISK TRANSFER: HANDLING RISK


Personal Risk Management: An Overview

Three steps to managing risk

1. Identify nature and cause of

the risk

2. Determine how much if any

risk you are willing to assume

3. Determine the best technique

for handling the risk


Risk Management Strategy


Risk Management StrategiesRisks Strategies for managing the

impactEvents Impact Personal Private PublicDisability

Loss of incomeIncreased expenses

SavingsFamily

InsuranceWorker’s Comp

Social Security

Illness Loss of incomeCatastrophic hospital expenses

SavingsHealthy living

Health InsuranceLong term care

Military benefitsMedicare, Medicaid

Death Loss of incomeFinal expenses

SavingsEstate Planning

Insurance Social Security survivors benefits

Retirement

Decreased income

Savings Retirement plans

Social security

Property Loss

Loss of ability to use

Smoke detectors

P&CFlood Ins

Federal disaster relief

Liability Lawsuits and expenses

HomeownersE&O, malpractice


Types of Insurances Available

Key reason for buying life insurance is to meet financial obligations in order to:

◦ Pay off final expenses, estate taxes, state inheritance taxes, and administration costs

◦ Provide for spouse, children, and other dependents◦ Provide funds for education ◦ Provide for a legacy to heirs or charity◦ Pay off all debts and mortgages


INTRODUCTION TO LIFE INSURANCE

◦Transfer ownership of business or protect business against loss of key employees

◦Maintain adequate emergency fund Very ineffective

◦Provide insurance for ex-spouse

◦Provide funds for charity

◦Create salary continuation plan for employees

◦Finance company’s obligations under continuation plan


Other Uses of Life Insurance

In Purchasing Life Insurance: Main objectives are to determine how

much insurance to purchase, and which type of insurance offers best value.

Secondary objective is to treat life insurance as a form of savings.◦Very poor investment vehicles


Purchasing Life Insurance


Theory of Decreasing Responsibility

Essential FeaturesRented for a specified time

Verbage to make it sound like a bad choice

Just like auto insuranceIf renewable, can be renewed upon expirationPremiums lower in earlier years, but jump

dramatically laterBetter phrased: as we get older any

continuation will cost moreBut if we want to increase coverage any

insurance will cost more later than now

Provides pure protection with no savings


TERM INSURANCE

Types of Term Insurance◦ Level Term

10 – 35 year terms◦ Renewable Term

Annual some 5 year◦ Convertible Term

May be more expensive than straight term May have to prove insurability but may be able to

“buy” guaranteed insurability Usually increase in cost or reduction in face value at

conversion◦ Decreasing Term

Credit life insurance Very expensive Usually not necessary


TERM INSURANCE

Important OptionsConvertibilityFlexibilityShopping for Term Policies


TERM INSURANCE

Essential Features Death protection

Of course no such thing Income protection better phrase

Permanence Do you need it forever?

Level Premiums (Figure 4-3)Cash value (Figure 4-4)

Cash value is the amount in the investment account after all expenses paid and any investment return has been added


CASH VALUE INSURANCE

Essential Features◦ Flexibility

Loans (bad idea) Do you have to pay yourself back?

Paid up policies; if you want tostop paying premiums Same face for a specific time Reduced face for a specific period of time

◦Level Premiums (Figure 4-4)◦ Dividend Option (more on this later)◦ Emergency Fund


Cash Value Insurance

Comparison of Level Premiums for $1,000 Insurance


Comparison of Level Premiums

How much would you pay per month for a $100,000 policy? This figure is misleading in

it’s attempt to convince you that term insurance is a bad choice. You can buy 35 year

fixed term.


People are Over-Premiumed and Under-Insured

Source: American Council of Life Insurance, 1998

• Whole life policy $100,000 at age 30 costs average of 100 * $17.12 = $1,712 per year.

• Term 100 * $2.58 = $258• Invest the difference for 35 years at 12%

($1,454)• End investment value = $627,638• A whole life policy can never exceed it’s

face value without endowing. This could create tax issues.


What does the difference mean?

Essential FeaturesGuaranteed fixed premiums Guaranteed death benefitOffers protection plus savingsConservative investments

Variation of Whole Life Insurance◦ Limited-Pay Whole Life◦ Modified or Graded-Premium Whole Life◦ Single-Premium Whole Life◦ Endowment Life◦ Current Assumption Whole Life◦ Return-of-Premium Whole Life

Important Issues Investment risk remains with the insurance company“Guaranteed” nature of this policyAppropriate for conservative person with long-term need


WHOLE LIFE INSURANCE


Cash Value Policies

Essential FeaturesPremium payments (timing and amounts) are flexibleDebt benefits is adjustable Investment risk shifts from insurance company to the

policyholderUnbundling of expenses and cash value accounts

Variation of Universal Life Insurance◦ Indexed universal life◦ Adjustable life insurance

Important IssuesHigh level of transparencyFlexibility of premium paymentsPolicy can be tailored to changing needs of policyholderOption A and Option B


UNIVERSAL LIFE INSURANCE

In contrast to whole life, universal life:

Premium payments are flexible. Death benefit is adjustable. Investment risk shifts from insurance

company to policyholder.


UNIVERSAL LIFE


How Universal Life Insurance Works


UL


Premium 595

1st

year

Charges

2.35% + 1.25% + 4% =

7.6%

45.22 + 240 + 96 =

381.22

(64%)

After first year

$141 (23.7%)

Does not include costs of

insurance

Essential FeaturesCash value and death benefit based on investment

performance of separate accountMinimum death benefit paid as long as premiums paid Investment risk shifts from insurance company to the

policyholder Variation of Variable Life Insurance

◦ Single-premium variable life◦ Variable-universal life

Important IssuesPolicyholder makes the investment decisions Investment choices include: equity mutual funds, fixed

income mutual funds and money market instrumentsAppropriate for policyholder with investment acumen


VARIABLE LIFE INSURANCE

SURVIVORSHIP LIFE POLICY First-to-Die Policies Second-to-Die Policies

Ownership Options Accelerated Death Benefits Living Death Benefits

FAMILY INCOME INSURANCE FOR INDIVIDUAL

FAMILY MEMBERS Spousal Insurance Insurance for Children


Other Life Insurance Policies

Ownership clause Incontestability clause Grace period Reinstatement clause Non-forfeiture clause Dividend options Policy loans Beneficiary provisions Suicide clause Simultaneous death clause


Life Insurance Contract

Accelerated death benefit Accidental death benefit Disability waiver of premium Disability income rider Family rider Guaranteed insurability option


Life Insurance Policy Riders

• Net Borrowing Cost– Ignores Opportunity Cost– Must pay back the loan or the interest

continues• Reduces Death Benefit• Taxed at Highest Rate if it Violates 7-

Pay Test• Desirable if Alternative Sources Not

Available (absolute last resort)

LOANS FROM LIFE INSURANCE POLICY


Basic Considerations◦ Will the original intent be followed◦ After distribution control goes to the beneficiary

Distribution◦ Lump-Sum Payment: Tax-Free◦ Fixed Annuity: Partially Taxable◦ “annuitization”

Control of money goes to insurance company

Fixed Period Option Fixed Income Option Life-income Option

LIFE INSURANCE SETTLEMENT OPTIONS


Annuitization◦The process of converting from a lump

sum into some form of a payment stream◦ Insurance company “insures” the payment

stream Insured loses control of the assets

◦PMT for Life What if die in 3 years

Insurance company keeps the rest◦Period certain

The insurance company guarantees a certain # of payments 10 year certain If die in 15 years the insurance company pays until

you die If die in 5 years, the insurance company would pay

to a beneficiary the amount that would have been received for 10 years, the insurance company would keep any excess

SETTLEMENT OPTIONS


TAXATION OF LIFE INSURANCE Distribution upon Death

Usually not taxable Distribution during Life• Dividends not taxable• Loans could be taxable• Cashing out could be taxable

LIFE INSURANCE AND ESTATE TAXES◦ If the owner, policy included in estate


Taxation

SWITCHING LIFE INSURANCE POLICIES

◦ Replacement should be watched carefully

◦ CV to CV could be churning◦ Term to CV

Convertible not really a switch◦ CV to term

Special reporting requirements

Switching


Buy-Sell Agreement Key Man Insurance Insurance for Professionals Group Life Insurance Split-Dollar Life Insurance Life Insurance in Qualified Plans Section 412(i) Plan Life Insurance in Non-Qualified Plan Welfare Benefit Trust


BUSINESS USES OF LIFE INSURANCE

• Buy-Sell Agreement– Partners would have insurance on other

partners. If a partner dies, the others receive a death benefit that they use to buyout the business interest from the deceased partner’s beneficiaries.

• Key Man Insurance– Used to help defray expenses incurred and

revenues lost if a critical employee dies.

• Split-Dollar Life Insurance– IRS has some rulings that may impact the taxation of this type of

strategy


Figure 4-6 How Do Split Dollar Policies Work


Split Dollar Policies

CAPITAL MAXIMIZING STRATEGY LIFE INSURANCE IN AN IRREVOCABLE TRUST LIFE SETTLEMENT OPTIONS LIVING DEATH BENEFITS POLICY ILLUSTRATIONS


MISCELLANEOUS LIFE INSURANCE ISSUES


How a Life Insurance Trust Works

1. UNDERSTAND THE CLIENT’S GOALS Income replacement Pre-funding children’s education Pay off debts Provide for final expenses and taxes (liquidity) Leaving a legacy

2. CALCULATE THE LIFE INSURANCE NEED3. IDENTIFY THE BEST TYPE OF POLICY 4. SELECT THE INSURANCE COMPANY5. PURCHASE THE POLICY


LIFE INSURANCE PLANNING

Table 4-5 Expense Needs Versus Sources of Income


Expense Needs Versus Sources of Income

ABILITY TO FUND PREMIUM PAYMENTSPOLICY SUITABILITY

Amount of death benefit neededDuration of the needClient factors

POLICY REPLACEMENT


POLICY SELECTION OR REPLACEMENT

FINANCIAL STABILITYCLIENT SERVICEREPUTATION FOR PAYING CLAIMSUNDERWRITING STANDARDSPOLICY PRICING


INSURANCE COMPANY SELECTION

Rating Agencies A.M. BEST Fitch Moody’s Standard &

Poor’s Weiss


RATINGS OF INSURANCE COMPANIES

Two Time-tested Methods: Human Value Approach

Based on Client’s Income Potential

Capital Needs AnalysisSufficient for Covering Family’s Economic needs


DETERMINATION OF LIFE INSURANCE NEEDS

Determination of Life Insurance Need


Table 4-8 Family and Financial Data for John Smith


INSURANCE NEEDS EXAMPLE:Gathering Data

Payoff mortgage?Payoff debt?Pay for kid’s education?Pay for final death expenses?Monthly income to replace?

Easier Format than in the text.



Primary Spouse

yes yesAmount? $175,000

yes noAmount? $45,000

yes noAmount? $25,000

yes yesAmount? $15,000

Primary Spouseamount? $2,925 $1,600time? $12 $12return? 8.00% 8.00%

enter yes or noPayoff Mortgage?

Payoff Debt?

Pay children's education?

Pay final expenses?

monthly income?

Amount of monthly income needed? Primary Spouseenter amounts

net income? $4,500 $2,500mortgage expenses? (if paid off with Ins) $1,400 $1,400Debt expenses? (if paid off with ins) $900 $0amount save for education? $75 $0change in child care costs? $500 $500any other changes in expenses? $300 $0minimum needed to replace income $2,925 $1,600

Primary Spouse$175,000 $175,000

$45,000 $0$25,000 $0$15,000 $15,000

$270,220 $147,812

$530,220 $337,812$150,000 $80,000

-$380,220 -$257,812

Approx. amt of ins neededCurrent Insurance CoverageInsurance Shortfall

DebtEducationFinal expenses

Monthly Income

Coverage needed

Mortgage

Ask the client (primary) what would you want

the insurance to cover if the spouse died? (fill in

under spouse column). Ask the spouse what

they want the insurance to cover should their

spouse die, fill in under primary.

Financial planning / life insurance needs

• Only cover what needs to be covered–Need a policy to cover mortgage and debts• Paid off in 15 years

–Need to cover kids education• Youngest will finish in 20 years

–Need a policy to cover income needs for surviving spouse until they retire 30 years from now or at least until they can find a way to replace the lost income.

Theory of decreasing responsibility


chapter 4

Documents

basics of risk management

current risk management

life insurance1chapter

life insurance4introduction

life insurancestructure

financial services chapter

financial planner

complicated financial