Chapter 8 Insuring Your Life How Will This Affect Me? Insurance should be used only to protect against potentially catastrophic losses, not for small risk exposures. It should cover losses that could derail your family’s future. It balances the relatively small, certain loss of ongoing premiums against low-probability, high-cost risks. This chapter focuses on how to go about buying life insurance. Premature death is clearly a catastrophic loss that could endanger your family’s financial future. We start by explaining how to determine the amount of life insurance that is right for you. We also consider how to choose among key insurance products, which include term life, whole life, universal life, variable life, and group life policies. The key features of life insurance contracts are explained, and frameworks for choosing an insurance agent and an insurance company are presented. The chapter will help you prepare to make informed life insurance decisions. Learning Objectives 8-1 Explain the concept of risk and the basics of insurance underwriting. Risk and underwriting are the focus of insurance. Risk is the chance of an economic loss. That loss may occur due to a car accident or health issues. To avoid the risk of a car accident, do not drive a car. To avoid health issues, be healthy. OK so there are costs associated with avoiding risk. Insurance allows you to transfer the risk of financial loss to the insurance company. Why will the insurance company take the risk? Their underwriting activities [statistical analysis of large number of insures] give the company information to set a price that will cover their expected loss plus a profit. 8-2 Discuss the primary reasons for life insurance and identify those who need coverage. The primary purpose of life insurance is to protect your dependents from financial loss in the event of your untimely death. If you have no one dependent upon you for resources, you do not need life insurance. You could ask the class if they have life insurance. If yes, why? If no, why? 8-3 Calculate how much life insurance you need. Need for life insurance is the first primary topic for this chapter. Worksheet 8.1 organizes the information to be considered in the insurance or not decision. It will help the students to walk through the worksheet. The multiple of earnings is a general estimation of your need for life insurance. The rule of thumb is 5 to 10 times you annual take-home pay. The needs analysis [of the worksheet] is more specific and gives a more appropriate measure of the need for life insurance. Point out that even though you have no income, you may still have needs that may be covered with life insurance. 8-4 Distinguish among the various types of life insurance policies and describe their advantages and disadvantages. The material here is mostly definitional and description. The text presents the material well. You could ask the students what some of the terms mean. You could copy the definition of several of the terms [say ten] and randomize the terms to create a matching question which could be a quiz to judge level of knowledge of these terms. The power point slides also cover this material. 8-5 Choose the best life insurance policy for your needs at the lowest cost. Choosing the best life insurance to fulfill the need is the second primary topic for this chapter. Most likely term insurance will be the winner. [My bias, as a side note my wife says only buy whole life that paid up at age 65.] The various forms of whole life have their purpose and may be best for some cases, but term is the easy sale. To paraphrase a sentence in the chapter, “People buy term insurance; you have to sell whole life.” Buy term and invest the difference is discussed at the end of the chapter. While it should be considered, it is a long-term strategy and requires discipline to make the investments. Exhibits 8.2, 8.3, 8.5, 8.6 and 8.7 gives some illustrative costs of insurance. Exhibit 8.8 overviews the various types of life insurance. 8-6 Become familiar with the key features of life insurance policies. Insurance companies do go bankrupt. The state insurance commission will normally find another insurance company to take over the policies of the bankrupt company. A rule of thumb is to always purchase life insurance from a company with one of the top two ratings. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • The best way to figure out how much life insurance you need is to use a multiple of your earnings. Fantasy: While the multiple earnings approach is probably the simplest procedure, it suffers from a number of serious shortcomings. A better choice is the needs approach. • Social security survivor’s benefits should be factored into your life insurance plans if you have a dependent spouse and/or minor children. Fact: Survivor’s benefits are paid to the dependents of eligible deceased workers and can be a big factor in helping your family meet their annual income needs. • Term insurance provides nothing more than a stipulated amount of death benefits and, as a result, is considered the purest form of life insurance. Fact: Term insurance provides a given amount of life insurance (i.e., death benefits) for a stipulated period of time and nothing more – no investments feature or cash value. • Selecting an insurance company is the first thing you should do when buying life insurance. Fantasy: The first thing you should do is determine the amount of life insurance you need and then select the type of policy that is best for you. Only after you have taken these steps should you address where you will buy the insurance. A rule of thumb is to always purchase life insurance from a company with one of the top two ratings. • Because most life insurance policies are largely the same, you need not concern yourself with differences in specific contract provisions. Fantasy: All insurance policies are not the same. Thus, it is important to familiarize yourself with the provisions of the contract, including the beneficiary clauses and settlement options. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. The questions are the same as above, just in the form of a quiz. 1. True False The best way to figure out how much life insurance you need is to use a multiple of your earnings. 2. True False Social security survivor’s benefits should be factored into your life insurance plans if you have a dependent spouse and/or minor children. 3. True False Term insurance provides nothing more than a stipulated amount of death benefits and, as a result, is considered the purest form of life insurance. 4. True False Selecting an insurance company is the first thing you should do when buying life insurance. 5. True False Because most life insurance policies are largely the same, you need not concern yourself with differences in specific contract provisions. Answers: 1. False 2. True 3. True 4. False 5. False YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. Shop for a Customized Life Insurance Policy Let’s make life insurance more concrete and personal. You can easily get an insurance quote online. Go to the popular Internet site noted in this chapter, http://www.insure.com/life-insurance/, and provide the requested personal information. Then request a quote for a 20-year, $200,000 term life insurance policy – you can do it now. Check Out the Best Life Insurance Companies The ratings of the best life insurance companies and an overall ranking, known as the Comdex rank, are provided online at http://toplifeinsurancereviews.com/comdex-ranking-life-insurance/. Go to the site and jot down the top five life insurance companies. Now you have a great start when you are ready to shop for life insurance - you can do it now. Buy term and invest the difference is a frequently stated plan. The “Financial Impact of Personal Choices” below demonstrates this plan and can be used to discuss buy term and invest the difference. Financial Impact of Personal Choices Amber and Josh Consider “Buying Term and Investing the Rest” Amber and Josh Peterson have two young children and believe it’s time to buy a life insurance policy to protect their family. They’ve both heard the life insurance advice to “buy term and invest the rest.” In order to evaluate this advice, they’ve collected quotes for 20-year term and whole life policies on Josh, both with a payoff of $250,000. The whole life policy premium is $347 a month while the term policy premium is only $23 a month. In 20 years the whole life policy will have a guaranteed cash value of $70,018 but at current rates would be worth $105,721. The death benefit will have grown to $326,352. If the Petersons buy the term policy and invest the $324 difference in monthly premiums at 8% for 20 years, they could have a portfolio worth about $190,843! The Petersons wonder about the financial consequences of their decision. It looks like buying term and investing the difference leaves the Petersons better off. Yet the financial consequences can only be fully evaluated in light of the Peterson’s objectives and attitude towards risk. The whole life insurance policy provides a guaranteed cash value in 20 years while the invested difference produces a higher expected but risky, unguaranteed payoff. And the Peterson’s must consider whether they will have the discipline to keep “investing the difference” over the next 20 years. Once the whole life policy’s cash value builds up, they could stop paying the premium by accepting some trade-offs in the value of the policy. In 20 years the term life insurance coverage will go away, which might be fine if the kids are gone and the mortgage is paid off. In contrast, the Petersons could stop paying the whole life policy premiums then and accept a reduced paid-up amount of coverage. The personal financial consequences of “buy term and invest the rest” suggest the advice may well work for the Petersons. But the best decision depends on their objectives, discipline, and attitude towards the risks of “investing the rest.” Source: Adapted from Chris Arnold, “Life Insurance: Is Buying Term and Investing the Difference Your Best Approach?” http://www.nerdwallet.com/blog/finance/advisorvoices/difference-term-life-insuranc/. Financial Planning Exercises Planning Exercises 1. Deciding if additional life insurance is needed and, if so, appropriate type. Use Worksheet 8.1. Harvey Cook, 45, is a recently divorced father of two children, ages 10 and 7. He currently earns $95,000 a year as an operations manager for a utility company. The divorce settlement requires him to pay $1,500 a month in child support and $400 a month in alimony to his ex-wife. She currently earns $35,000 annually as a schoolteacher. Harvey is now renting an apartment, and the divorce settlement left him with about $100,000 in savings and retirement benefits. His employer provides a $75,000 life insurance policy. Harvey’s ex-wife is currently the beneficiary listed on the policy. What advice would you give to Harvey? What factors should he consider in deciding whether to buy additional life insurance at this point in his life? If he does need additional life insurance, what type of policy or policies should he buy? Use Worksheet 8.1 to help answer these questions for Harvey. See Worksheet 8.1 below. Divorce is always a difficult situation, especially with children involved. Harvey has to decide the level of support he wishes to give his children. If he wants to provide a college fund for his kids, he will need at least $200,000 to cover basic college education. If he dies, he only has $175,000 in resources available for college, child support, alimony and funeral expenses. Assuming $200,000 college fund, child support of $198,000 ($1,500 per month * 12 months * 11 years—until younger child is 18), alimony $52,800 [$400 per month * 12 months * 11 years] and funeral expenses of $10,000, Harvey needs insurance of $460,800. If the college fund is left out, that need reduces to only $260,800. If alimony continues for life of ex-spouse and that she is about 45 and expected to live another 33 years [until age78] which is 22 years beyond time younger goes to college, his needs increases to $566,400 [460,800 + 105,600 (400 * 12 *22)]and additional insurance increases to $391,400 [566,400 – 175,000]. In 11 years, both kids will be in college. The funds for college will be available from savings and not need life insurance. Also, child support payments stop. So when reaches 56 [45 + 11] the only insurance need will be for alimony of $400 per month. Again, assuming ex-wife lives another 22 years beyond the time kids go to college, that is $105,600 and the amount reduces each year. His funeral needs are only $10,000, for a total need of $115,600. His investment and company insurance will be enough to cover this need. Accordingly, he needs no additional insurance for that period, i.e. after kids are in college. Given his age, I would suggest term insurance for the next 11 years. He will not have need for additional insurance after the kids are in college. 2. Estimating life insurance needs. Use Worksheet 8.1. Sophie Lopez is a 72-year-old widow who has recently been diagnosed with Alzheimer’s disease. She has limited financial assets of her own and has been living with her daughter Felicity for two years. Her only income is $850 a month in Social Security survivor’s benefits. Felicity wants to make sure her mother will be taken care of if Felicity should die prematurely. Felicity, 40, is single and earns $55,000 a year as a human resources manager for a small manufacturing firm. She owns a condo with a current market value of $100,000 and has a $70,000 mortgage. Other debts include a $5,000 auto loan and $500 in various credit card balances. Her 401(k) plan has a current balance of $24,500, and she keeps $7,500 in a money market account for emergencies. After talking with her mother’s doctor, Felicity believes that her mother will be able to continue living independently for another two to three years. She estimates that her mother would need about $2,000 a month to cover her living expenses and medical costs during this time. After that, Felicity’s mother will probably need nursing home care. Felicity calls several local nursing homes and finds that it will cost about $5,000 a month when her mother enters a nursing home. Her mother’s doctor says it is difficult to estimate her mother’s life expectancy but indicates that with proper care some Alzheimer’s patients can live 10 or more years after diagnosis. Felicity also estimates that her personal final expenses would be around $5,000, and she’d like to provide a $25,000 contingency fund that would be used to pay a trusted friend to supervise her mother’s care if Felicity were no longer alive. Use Worksheet 8.1 to calculate Felicity’s total life insurance requirements and recommend the type of policy that she should buy. Felicity is concerned that if she should die, her mother will not able to get the care she needs. While it is difficult to estimate lives, Felicity believes that her mother will live no more than 13 additional years. At Felicity’s death, Sophie [Mother] will only have her social security which does not cover her expenses now. The needs analysis, Worksheet 8.1 below, indicates that Felicity will need $512,900 of additional life insurance to provide for her mother’s care for the rest of her life. Felicity is 40 now. Given Felicity’s middle age and the major need for insurance is for only an additional 13 years, Felicity should purchase 15-year term life insurance. After her mother dies, she will no longer have need for life insurance. With 15-year term, the premiums will be fixed for 15 years. It is not clear that Felicity can afford any insurance given the cost of caring for her mother. If Felicity does not die, she will have to find funds to cover her mother’s costs. Life insurance only pays if the insured dies. Perhaps the mother will qualify for Medicaid given her Alzheimer’s disease. With a salary of $55,000, Felicity cannot provide her mother with the support she needs, $24,000 per year now; $60,000 per year later. Long-term care insurance will not be available given mother’s age and medical condition. 3. Appropriateness of whole life insurance. Martha and Louis Mitchell are a dual-career couple who just had their first child. Louis age 30, already has a group life insurance policy, but Martha’s employer does not offer a life insurance benefit. A financial planner is recommending that the 27-year-old Martha buy a $250,000 whole life policy with an annual premium of $1,670 (the policy has an assumed rate of earnings of 5 percent a year). Help Martha evaluate this advice and decide on an appropriate course of action. Issues are the need for insurance and then what type of insurance best meet that need. We do not know the amount of Pablo’s insurance. Frequently employer provided group life insurance is term insurance for twice the employee’s annual salary. The need for insurance centers around the care for her child. The amount of $250,000 could be correct, but a needs analysis should be performed. The second issue is what type of insurance. For younger couples, term insurance is normally preferred versus whole life. Using the table is Exhibit 8.3, the premium for 20-year level premium term life of $100,000 for a 25-year old female is $108, thus, for $250,000 the premium would be 2.5 * 108 = $270 per year. The child would be 20 years old at the end of the term and most likely the amount of insurance Ramona needs will change. The difference in annual premium between term and whole life [$1,670 – 270 = $1,400] could be invested in a mutual fund. If the fund earned 6% over the 20 period, at the end of 20 years it would amount to about $51,500. My advice to Ramona is to first determine the need for insurance. Once the amount is determined, I suggest she purchase level premium term insurance. If she has the funds, I would urge her to invest the additional amount in some mutual fund that invests in equity securities. Note the Financial Impact of Personal Choices, Amber and Josh Consider “Buying Term and Investing the Rest” that is at the end of the chapter. [Above in these materials.] 4. Appropriateness of variable life insurance. While at lunch with a group of coworkers, one of your friends mentions that he plans to buy a variable life insurance policy because it provides a good annual return and is a good way to build savings for his 5-year-old’s college education. Another colleague says that she’s adding coverage through the group plan’s additional insurance option. What advice would you give them? A variable life insurance policy goes further than whole and universal life policies in combining death benefits and savings. The policyholder decides how to invest the money in the savings (cash-value) component. The investment accounts are set up just like mutual funds, and most firms that offer variable life policies let you choose from a full menu of different funds, ranging from money market accounts and bond funds to international investments or aggressively managed stock funds. The friend is mixing investment and insurance. If the goal is to build an education fund, then the funds need to be investment in stocks or mutual funds, securities that will build in value over the 15 years until the child is 20 and in college. Those funds could be protected by purchasing term life insurance to cover the case of premature death. Perhaps the group plan will be the source of that term. Variable life insurance is not appropriate for a college fund. If you want the benefits of higher investment returns, then you must also be willing to assume the risks of reduced insurance coverage. So, what does this mean for you? It means you should use extreme care when buying variable life insurance. 5. Choosing among types of life insurance. Camila Rodriguez, a 38-year-old widowed mother of three children (ages 12,10, and 4), works as a product analyst for a major consumer products company. Although she’s covered by a group life insurance policy at work, she feels, based on some rough calculations, that she needs additional protection. Leon Thompson, an insurance agent from Insurance Advisers, has been trying to persuade her to buy a $150,000, 25-year, limited payment whole life policy. However, Camila favors a variable life policy. To further complicate matters, Camila’s father feels that term life insurance is more suitable to the needs of her young family. a. Explain to Camila the differences between (i) a whole life policy, (ii) a variable life policy, and (iii) a term life policy. (i) Whole life policy: Policy provides insurance and many options such as single premium, paid up at 55 or 65, builds cash value, ability to borrow cash value, and lots of agent contact. All of this comes at a higher price than other types. (ii) Variable life policy: Insurance plus investment options that are controlled by the insured (iii) Term live policy: Provides insurance and nothing else. The insurance is provide for a specified time period and may or may not be renewable for additional time. b. What are the major advantages and disadvantages of each type of policy? Exhibit 8-8 lists the major advantages and disadvantages of the various types of life insurance.
Type of Policy Advantages Disadvantages
Term Low initial premiums Simple, easy to buy Provides only temporary coverage for a set period May have to pay higher premiums when policy is renewed.
Whole Life Permanent coverage Savings vehicle: cash value builds as premiums are paid Some tax advantages on accumulated earnings Cost: provides less death protection per premium dollar than term Often provides lower yields than other investment vehicles Sales commissions and marketing expenses can increase costs of fully loaded policy.
Universal Life Permanent coverage Flexible: lets insured adapt level of protection and cost of premiums Savings vehicle: cash value builds at current rate of interest Savings and death protection identified separately Can be difficult to evaluate true cost at time of purchase; insurance carrier may levy costly fees and charges Interest rate changes may adversely affect future cash values or expected premium payments, which may even cause the policy to lapse
Variable Life Investment vehicle: insured decides how cash value will be invested Higher risk
c. In what way is a whole life policy superior to either a variable life or term life policy? In what way is a variable life policy superior? How about term life insurance? Whole life: many features as noted in part a. Variable life: Investment features. Term life: Cost is lower d. Given the limited information in the case, which type of policy would you recommend for Camila? Explain your recommendation. From the information provided, I expect that Camila’s need for insurance is related to her kids and the kids to provide for them in the case of her premature death. She also appears to want to have an investment program such as if available with variable life. I suggest she separate the two needs. Buy term insurance to protect her kids in case of her premature death. Start an investment program with monthly transfers of funds into a mutual fund. In other words, buy term and invest the difference. 6. Life insurance premiums and comparison of types. Using the premium schedules provided in Exhibits 8.2, 8.3, and 8.5, how much in annual premiums would a 25-year-old male have to pay for $100,000 of annual renewable term, level premium term, and whole life insurance? (Assume a five-year term or period of coverage.) How much would a 25-year-old woman have to pay for the same coverage? Consider a 40-year-old male (or female): Using annual premiums, compare the cost of 10 years of coverage under annual renewable and level premium term options and whole life insurance coverage. Relate the advantages and disadvantages of each policy type to their price differences. Policy is $100,000, for 10 years
Insured Annual renewable term Level premium term Whole life insurance
25-yr male $164 * 5 + $167 * 5 = $1,655 $120* 10 = $1,200 $1,057 * 5 + $1,218 * 5 = $11,375
25-yr female $143 * 5 + $150 * 5 = $1,465 $108* 10 = $1,080 $956 * 5 + $1,099 * 5 = $10,275
40-yr male $188 * 5 + $228 * 5 = $2,080 $144* 10 = $1,440 $1,749 * 10 = $17,490
40-yr female $178 * 5 + $225 * 5 = $2,015 $135* 10 = $1,350 $1,499 * 10 = $14,990
I did not interpolate to estimate the yearly premium for the annual renewable term or the whole life insurance. I just used the 5-year and the 10-year premiums. The comparison will be similar for the policies. The premiums demonstrate that, in general, rates for men are higher than for women of the same age; that premiums increase with age; and that term insurance is far less expensive than whole life. The annual renewable term is the lowest cost for the 25-yr olds and the level term for the 40-yr olds. The whole life is substantially more expensive. The whole life gives an accumulating cash value [about $8,000] plus guaranteed renewability. The renewable term gives the renewability which is the more valuable of the characteristics of the whole life. It is hard to justify the whole life policy given all of the options now available with term policies. This is especially true if you invest the difference between premiums. 7. Using Insurance policy illustrations. Describe the key elements of an insurance policy illustration and explain what a prospective client should focus on in evaluating an illustration. Focus should be on needs for insurance, that is what risks does the client have. The age of the client greatly impacts the cost of insurance. The renewability of the insurance should be addressed. People do become uninsurable and that is a risk to be considered. The ability of the client to make consistent investment could impact the type of insurance. The assumptions underlying the estimates of cash value and premium costs should be clearly stated. Test Yourself Questions 8-1 Discuss the role that insurance plays in the financial planning process. Why is it important to have enough life insurance? Insurance is intended to protect you and your family from the financial consequences of losing assets or income when an accident, illness, or death occurs. By anticipating the potential risks to which your assets and income could be exposed and by weaving insurance protection into your financial plan, you lend a degree of certainty to your financial future. 8-2 Define (a) risk avoidance, (b) loss prevention, (c) loss control, (d) risk assumption, and (e) an insurance policy. Explain their interrelationships. a. risk avoidance -- Avoiding an act that would create a risk. Risk avoidance is an attractive way to deal with risk only when the estimated cost of avoidance is less than the estimated cost of handling it in some other way. b. loss prevention -- Any activity that reduces the probability that a loss will occur. c. loss control -- Any activity that lessens the severity of loss once it occurs. Together Loss prevention and loss control should be important parts of the risk management program of every individual and family. d. risk assumption -- The choice to accept and bear the risk of loss. Risk assumption can be an effective way to handle many types of potentially small exposures to loss when insurance would be too expensive. e. insurance policy -- A contract between the insured and the insurer under which the insurer agrees to reimburse the insured for any losses suffered according to specified terms. From your perspective, you are transferring your risk of loss to the insurance company. All of these are ways to handle risk that individuals [as well as businesses] handle risks that occur in all of our lives. A good financial plan will use all of these to protect against the loss of your accumulated wealth. 8-3 Explain the purpose of underwriting. What are some factors that underwriters consider when evaluating a life insurance application? Underwriting -- The process used by insurers to decide who can be insured and to determine applicable rates that will be charged for premiums. Insurers are always trying to improve their underwriting capabilities in order to set premium rates that will adequately protect policyholders and yet be attractive and reasonable. Underwriters gather data from a variety of sources which they the statistically analyze to determine the appropriate premiums. 8-4 Discuss some benefits of life insurance in addition to protecting family members financially after the primary wage earner’s death. The major benefits are financial protection for dependents, protection from creditors [with proper planning, life insurance benefits can be excluded from an estate], tax benefits [generally, benefits from life insurance policies are excluded from gross income] and some type of life insurance can serve as a savings vehicle. 8-5 Explain the circumstances under which a single college graduate would or would not need life insurance. What life-cycle events would change this initial evaluation, and how might they affect the graduate’s life insurance needs? Life insurance should be considered if you have dependents counting on you for financial support. Thus, it is possible that parents or other relatives are relying on the college student to provide some assistance in the near term. If the student dies, these relatives would be in financial difficulty. If there is no one relying on you for resources, you do not need life insurance. 8-6 Discuss the two most commonly used ways to determine a person’s life insurance needs. You can use one of two methods to estimate how much insurance is necessary: the multiple-of-earnings method and the needs analysis method. The multiple-of-earnings method takes your gross annual earnings and multiplies it by some selected (often arbitrary) number to arrive at an estimate of adequate life insurance coverage. The rule of thumb used by many insurance agents is that your insurance coverage should be equal to 5 to 10 times your current income. A more detailed approach is the needs analysis method. This method considers both the financial obligations and financial resources of the insured and his or her dependents; it involves three steps, as shown in Exhibit 8.1: 1. Estimate the total economic resources needed if the individual were to die. 2. Determine all financial resources that would be available after death, including existing life insurance and pension plan death benefits. 3. Subtract available resources from the amount needed to determine how much additional life insurance is required. 8-7 Name and explain the most common financial resources needed after the death of a family breadwinner. From Exhibit 8.1: Total economic needs include: Income needed to maintain an adequate lifestyle Extra expenses if the income producer dies: Included here would be the end of life expenses [last medical care and funeral expenses] Special needs of dependents Debt liquidation Liquidity: Life for the survivors will change. They will need cash to make the type of changes they will face. 8-8 What are some factors that underwriters consider when evaluating a life insurance application? Which, if any, apply to you or your family members? Life insurance underwriting begins by asking potential insureds to complete an application designed to gather information about their risk potential. In other words, underwriters consider the likelihood that the insured will die while the life insurance policy is in effect. Underwriters use life expectancy figures to look at overall longevity for various age groups. They also consider specific factors related to the applicant’s health. Someone who smokes, is obese, has a history of heart disease, or has a dangerous job or hobby is considered a greater risk than someone who doesn’t. Applicants who have been charged with driving under the influence of drugs or alcohol or who have had their driver’s license suspended may also be viewed as riskier. 8-9 What is term life insurance? Describe some common types of term life insurance policies. Term life insurance is the simplest type of insurance policy. You purchase a specified amount of insurance protection for a set period. If you die during that time, your beneficiaries will receive the full amount specified in your policy. Types of term life insurance policies include: straight term policy -- A term insurance policy written for a given number of years, with coverage remaining unchanged throughout the effective period. decreasing term policy -- A term insurance policy that maintains a level premium throughout all periods of coverage while the amount of protection decreases.. renewability [renewable term] -- A term life policy provision allowing the insured to renew the policy at the end of its term without having to show evidence of insurability. Convertibility [Convertible term] -- A term life policy provision allowing the insured to convert the policy to a comparable whole life policy. 8-10 What are the advantages and disadvantages of term life insurance? Advantages are the cost and options like renewability and convertibility. Disadvantages include the requirement that you are insurable when the policy expires which is the reason you prefer to have renewable term. Also, the cost advantage is reduced as you get older [50+]. Buying longer term policies [20 year] can reduce some of the increase in cost. 8-11 Explain how whole life insurance offers financial protection to an individual throughout his or her life. In addition to death protection, whole life insurance has a savings feature (called cash value) that results from the investment earnings on paid-in insurance premiums. Thus, whole life provides not only insurance coverage, but also a modest [small] return on your investment. Also whole life premium can be a continuous premium, that is, it does not increase during your life. 8-12 Explain how the “paid-up insurance” component of a whole life insurance policy works. Paid-up insurance is a single premium whole life policy that is purchased with one cash premium payment at the inception of the contract, thus buying life insurance coverage for the rest of your life. Also whole life policies may have a conversion feature that allows you to convert to paid-up insurance at some specified time, such as year 20 of the policy. Such option gives guaranteed insurance protection with no additional premiums. 8-13 Describe the different types of whole life policies. What are the advantages and disadvantages of whole life insurance? Three major types of whole life policies are available: continuous premium, limited payment, and single premium. Under a continuous premium whole life policy—or straight life, as it’s more commonly called—individuals pay a level premium each year until they either die or exercise a nonforfeiture right. With a limited payment whole life policy, you’re covered for your entire life, but the premium payment is based on a specified period—for example, so-called 20-pay life and 30-pay life require level premium payments for a period of 20 and 30 years, respectively. In all of these cases, on completion of the scheduled payments, the insurance remains in force, at its face value, for the rest of the insured’s life. A single premium whole life policy is purchased with one cash premium payment at the inception of the contract, thus buying life insurance coverage for the rest of your life. Advantages include the ability to have insurance protection your entire life regardless of your insurability in later years. Ability to borrow against the cash value of the policy with repayment deferred until death. Ability to purchase “paid-up at year 20” policies gives high protection for a time, with paid-up insurance at the end of the stated term. One disadvantage of whole life insurance is its cost. It provides less death protection per premium dollar than term insurance does. 8-14 What is universal life insurance? Explain how it differs from whole life and variable life insurance. Universal life insurance is another form of permanent cash-value insurance that combines term insurance, which provides death benefits, with a tax-sheltered savings/investment account that pays interest, usually at competitive money market rates. Universal life is a form of “buy term, invest the difference” insurance plan that many recommend. The return on the investment is low, money market rates, but there is a return. Advantages include flexibility, savings feature, ability to change premiums and insurance protection. Disadvantage include the high fees including front-end commissions. 8-15 Explain how group life insurance differs from standard term life insurance. What do employees stand to gain from group life? Under group life insurance, one master policy is issued and each eligible group member receives a certificate of insurance. Group life is nearly always term insurance, and the premium is based on the group’s characteristics as a whole rather than the characteristics of any specific individual. The major advantage is the cost savings. 8-16 Why should the following types of life insurance contracts be avoided? (a) credit life insurance, (b) mortgage life insurance, (c) industrial life insurance (home service life insurance). These are the most expensive ways to purchase insurance. Other types of life insurance can serve the same purpose, with much lower premiums. 8-17 Briefly describe the steps to take when you shop for and buy life insurance. Several factors should be considered when making the final purchase decision: (1) comparing the costs and features of competitive products, [Exhibit 8.8 gives major advantages and disadvantages of the most popular types of life insurance. Section 8.6 discusses the key feature of the various types of life insurance.] (2) selecting a financially healthy insurance company [Private rating agencies have gather information about the various companies and graded the company. The four most commonly used agencies are A. M. Best, Fitch, Moody’s, and Standard & Poor’s (see Section 8-5b).], and (3) choosing a good agent [When seeking a good life insurance agent, try to obtain recommendations from other professionals who work with agents.]. 8-18 Briefly describe the insurance company ratings assigned by A. M. Best, Moody’s, Fitch, and Standard & Poor’s. Why is it important to know how a company is rated? What ratings would you look for when selecting a life insurance company? Explain. These agencies use publicly available financial data from insurance companies to analyze their debt structure, pricing practices, and management strategies in an effort to assess their financial stability. The purpose is to evaluate the insurance company’s ability to pay future claims made by policyholders, which is known as its claims paying ability. You want to be as sure as you can that the policy will be paid when the time comes. Most experts agree that it’s wise to purchase life insurance only from insurance companies that are assigned ratings by at least two of the major rating agencies and are consistently rated in the top two or three categories 8-19 What characteristics would be most important to you when choosing an insurance agent? Competent, as indicated by the agent’s education and certifications. Also you want an agent who will listen to your needs and answer your questions, regardless how stupid they may be. When seeking a good life insurance agent, try to obtain recommendations from other professionals who work with agents. 8-20 What is a beneficiary? A contingent beneficiary? Explain why it’s essential to designate a beneficiary for your policy. The beneficiary is the person who will receive the death benefits of the policy on the insured’s death. If the primary beneficiary does not survive the insured, then the insurer will distribute the death benefits to the contingent beneficiary or beneficiaries. If no beneficiary is named, the proceeds from the policy will be passed to the estate and distributed by will or by the court following the state law. 8-21 Explain the basic settlement options available for the payment of life insurance proceeds upon a person’s death. • Lump sum: This is the most common settlement option, chosen by more than 95 percent of policyholders. The entire death benefit is paid in a single amount, allowing beneficiaries to use or invest the proceeds soon after death occurs. • Interest only: The insurance company keeps policy proceeds for a specified time; the beneficiary receives interest payments, usually at some guaranteed rate. This option can be useful when there’s no current need for the principal—for example, proceeds could be left on deposit until children go to college, with interest supplementing family income. Typically, however, interest rates paid by insurers are lower than those available with other savings vehicles. • Fixed period: The face amount of the policy, along with interest earned, is paid to the beneficiary over a fixed time period. For example, a 55-year-old beneficiary may need additional income until Social Security benefits start. • Fixed amount: The beneficiary receives policy proceeds in regular payments of a fixed amount until the proceeds run out. • Life income: The insurer guarantees to pay the beneficiary a certain payment for the rest of his or her life, based on the beneficiary’s sex, age when benefits start, life expectancy, policy face value, and interest rate assumptions. This option appeals to beneficiaries who don’t want to outlive the income from policy proceeds and so become dependent on others for support. An interesting variation of this settlement option is the life-income-with-period-certain option, whereby the company guarantees a specified number of payments that would pass to a secondary beneficiary if the original beneficiary dies before the period ends. 8-22 What do nonforfeiture options accomplish? Differentiate between paid-up insurance and extended term insurance. A nonforfeiture option gives a cash value life insurance policyholder some benefits even when a policy is terminated before its maturity. Insurance companies usually offer the two options—paid-up insurance and extended term insurance. Paid-up insurance: The policyholder receives a policy exactly like the terminated one, but with a lower face value. Extended term insurance: The insured uses the accumulated cash value to buy a term life policy for the same face value as the lapsed policy. With paid-up insurance, you have insurance for life. With extended term insurance, you have insurance for the specified term only. 8-23 Explain the following clauses often found in life insurance policies: (a) multiple indemnity clause, (b) disability clause, and (c) suicide clause. Give some examples of common exclusions. a. Multiple indemnity clause: Multiple indemnity clauses increase the face amount of the policy, most often doubling or tripling it, if the insured dies in an accident. b. Disability clause: A disability clause may contain a waiver-of-premium benefit alone or coupled with disability income. A waiver-of-premium benefit excuses the payment of premiums on the life insurance policy if the insured becomes totally and permanently disabled prior to age 60 (or sometimes age 65). c. Suicide clause: Nearly all life insurance policies have a suicide clause that voids the contract if an insured commits suicide within a certain period, normally two years after the policy’s inception. Exclusions: Although all private insurance policies exclude some types of losses, life policies offer broad protection. Other than the suicide clause, the only common exclusions are aviation, war, and hazardous occupation or hobby. 8-24 Describe what is meant by a participating policy, and explain the role of policy dividends in these policies. In a participating policy, the policyholder is entitled to receive policy dividends reflecting the difference between the premiums that are charged and the amount of premium necessary to fund the actual mortality experience of the company. 8-25 Describe the key elements of an insurance policy illustration and explain what a prospective client should focus on in evaluating an illustration. A life insurance policy illustration is a hypothetical representation of a policy’s performance that reflects the most important assumptions that the company relies on when presenting the policy results to a prospective client. Insurance illustrations are complicated and often contain more than 20 pages of numbers and legal disclaimers. When you look at an insurance illustration, focus first on the basic assumptions that the company used to compute it, including your age, sex, and underwriting health status. Check to make sure that all the following sections are present in the narrative summary of the illustration and that no pages are missing. Critical Thinking Cases 8.1 Jun Hsieh’s Insurance Decision: Whole Life, Variable Life, or Term Life? Jun Hsieh, a 38-year-old widowed mother of three children (ages 12, 10, and 4), works as a product analyst for Panama Hats. Although she’s covered by a group life insurance policy at work, she feels, based on some rough calculations, that she needs additional protection. Phil Griffin, an insurance agent from Safety First Insurance, has been trying to persuade Jun to buy a $150,000, 25-year, limited payment whole life policy. However, Jun favors a variable life policy. To further complicate matters, Jun’s father feels that term life insurance is more suitable to the needs of her young family. Critical Thinking Questions 1. Explain to Jun the differences between (a) a whole life policy, (b) a variable life policy, and (c) a term life policy. a. Three major types of whole life policies are available: continuous premium, limited payment, and single premium. Under a continuous premium whole life policy—or straight life, as it’s more commonly called—individuals pay a level premium each year until they either die or exercise a nonforfeiture right. With a limited payment whole life policy, you’re covered for your entire life, but the premium payment is based on a specified period—for example, so-called 20-pay life and 30-pay life require level premium payments for a period of 20 and 30 years, respectively. In all of these cases, on completion of the scheduled payments, the insurance remains in force, at its face value, for the rest of the insured’s life. A single premium whole life policy is purchased with one cash premium payment at the inception of the contract, thus buying life insurance coverage for the rest of your life. b. A variable life insurance policy goes further than whole and universal life policies in combining death benefits and savings. The policyholder decides how to invest the money in the savings (cash-value) component. The investment accounts are set up just like mutual funds, and most firms that offer variable life policies let you choose from a full menu of different funds, ranging from money market accounts and bond funds to international investments or aggressively managed stock funds. c. term life insurance is insurance that provides only death benefits, for a specified period, and does not provide for the accumulation of cash value. It can be renewable up to an age limit. It can have level premiums for a term of several years. 2. What are the major advantages and disadvantages of each type of policy? Whole life: Advantages include the ability to have insurance protection your entire life regardless of your insurability in later years, Ability to borrow against the cash value of the policy with repayment deferred until death, and Ability to purchase “paid-up at year 20” policies gives high protection for a time, with paid-up insurance at the end of the stated term. One disadvantage of whole life insurance is its cost. It provides less death protection per premium dollar than term insurance does. Variable life: If you want the benefits of higher investment returns, then you must also be willing to assume the risks of reduced insurance coverage. So what does this mean for you? It means you should use extreme care when buying variable life insurance. Term life: The advantages is that you get the most insurance for the premium dollar. The disadvantages include the raising premium as you grow older and the potential that you will not be able to renew if you should become uninsurable due to health. 3. In what way is a whole life policy superior to either a variable life or term life policy? In what way is a variable life policy superior? How about term life insurance? Whole life gives a set amount of insurance that will not be cancelled as long as premiums are paid. It will build some cash value and you may be able to borrow that cash value. With variable life, the amount of insurance will variable based upon the returns from your choice of investment. With term, the premium rises with age and renewal is not guaranteed. Variable life will be great if the investments was wise and have a high return—a risky state to be in. Term gives the most insurance for your premium dollar. 4. Given the limited information in the case, which type of policy would you recommend for Ms. Hsieh? Defend and explain your recommendations. In 25 years Ms. Hsieh will have no one depending on her for resources. The youngest child will be 29 and should be on their own. Ms. Hsieh will be 63 and approaching retirement. Her need for insurance covers a 20 year period. She needs to build a retirement fund for herself. Thus, I would recommend she purchase term insurance and also begin saving for retirement. 8.2 The Jennings Want to Know: How Much Is Enough? Darrell and Lena Jennings are a two-income couple in their early 30s. They have two children, ages 6 and 3. Darrell’s monthly take-home pay is $3,600, and Lena’s is $4,200. The Jennings feel that, because they’re a two-income family, they both should have adequate life insurance coverage. Accordingly, they are now trying to decide how much life insurance each one of them needs. To begin with, they’d like to set up an education fund for their children in the amount of $120,000 to provide college funds of $15,000 a year—in today’s dollars—for four years for each child. Moreover, if either spouse should die, they want the surviving spouse to have the funds to pay off all outstanding debts, including the $210,000 mortgage on their house. They estimate that they have $25,000 in consumer installment loans and credit cards. They also project that if either of them dies, the other probably will be left with about $10,000 in final estate and burial expenses. Regarding their annual income needs, Darrell and Lena both feel strongly that each should have enough insurance to replace her or his respective current income level until the youngest child turns 18 (a period of 15 years). Although neither Darrell nor Lena would be eligible for Social Security survivor’s benefits because they both intend to continue working, both children would qualify in the (combined) amount of around $1,800 a month. The Jennings have amassed about $75,000 in investments, and they have a decreasing term life policy on each other in the amount of $100,000, which could be used to partially pay off the mortgage. Darrell also has an $80,000 group policy at work and Lena a $100,000 group policy. Critical Thinking Questions 1. Assume that Darrell’s gross annual income is $54,000 and Lena’s is $64,000. Their insurance agent has given them a multiple earnings table showing that the earnings multiple to replace 75 percent of their lost earnings is 8.7 for Jacob and 7.4 for Lena. Use this approach to find the amount of life insurance each should have if they want to replace 75 percent of their lost earnings. Using the earnings multiple calculation, the Jennings’ insurance needs are: 2. Use Worksheet 8.1 to find the additional insurance needed on both Darrell’s and Lena’s lives. (Because Darrell and Lena hold secure, well-paying jobs, both agree that they won’t need any additional help once the kids are grown; both also agree that they’ll have plenty of income from Social Security and company pension benefits to take care of themselves in retirement. Thus, when preparing the worksheet, assume “funding needs” of zero in Periods 2 and 3.) The worksheets are below. One assumption is that the decreasing term that they each have pays $100,000 at the death of the insured. Since it is decreasing term that is most likely overstating the amount of insurance that will be received by the survivor. The worksheet results suggest that Darrell needs to have insurance on his life of $434,000, which because of the decreasing term, should be rounded to $500,000. The worksheet results suggest that Lena needs to have insurance on his life of $522,000, which because of the decreasing term, should be rounded to $600,000. 3. Is there a difference in your answers to Questions 1 and 2? If so, why? Which number do you think is more indicative of the Jennings’ life insurance needs? Using the amounts computed in Question 2 (employing the needs approach), what kind of life insurance policy would you recommend for Darrell? For Lena? Briefly explain your answers. One difference is that the earnings multiple calculation is designed to replace 75% of the lost income. In the Worksheet analysis, the assumption is that 100% of the income is needed. Also, the worksheet is a more specific needs analysis than the general earnings multiple calculation. The more specific analysis provided by the worksheet is the better measure of their insurance needs. The insurance needs are for a specific period of 15 years, until the children completes college. After that time, they believe that their income and retirement income will be sufficient and they will need no additional insurance. This is a case for term insurance. The best insurance for the premium dollar is level premium term for their time of need (15 years). So I would recommend term insurance for both Darrell and Lena. Terms Found in the Chapter
beneficiary A person who receives the death benefits of a life insurance policy after the insured’s death.
disability clause A clause in a life insurance contract containing a waiver-of-premium benefit alone or coupled with disability income.
cash value The accumulated refundable value of an insurance policy; results from the investment earnings on paid-in insurance premiums.
convertibility A term life policy provision allowing the insured to convert the policy to a comparable whole life policy.
credit life insurance Life insurance sold in conjunction with installment loans.
decreasing term policy A term insurance policy that maintains a level premium throughout all periods of coverage while the amount of protection decreases.
guaranteed purchase option An option in a life insurance contract giving the policyholder the right to purchase additional coverage at stipulated intervals without providing evidence of insurability.
group life insurance Life insurance that provides a master policy for a group; each eligible group member receives a certificate of insurance.
industrial life insurance (home service life insurance) Whole life insurance issued in policies with relatively small face amounts, often $1,000 or less.
insurance policy A contract between the insured and the insurer under which the insurer agrees to reimburse the insured for any losses suffered according to specified terms.
life insurance policy illustration A hypothetical representation of a life insurance policy’s performance that reflects the most important assumptions that the insurance company relies on when presenting the policy results to a prospective client.
loss control Any activity that lessens the severity of loss once it occurs.
loss prevention Any activity that reduces the probability that a loss will occur.
mortgage life insurance A term policy designed to pay off the mortgage balance in the event of the borrower’s death.
multiple indemnity clause A clause in a life insurance policy that typically doubles or triples the policy’s face amount if the insured dies in an accident.
multiple-of-earnings method A method of determining the amount of life insurance coverage needed by multiplying gross annual earnings by some selected number.
needs analysis method A method of determining the amount of life insurance coverage needed by considering a person’s financial obligations and available financial resources in addition to life insurance.
nonforfeiture right A life insurance feature giving the whole life policyholder, upon policy cancellation, the portion of those assets that were set aside to provide payment for the future death claim.
participating policy A life insurance policy that pays policy dividends reflecting the difference between the premiums that are charged and the amount of premium necessary to fund the actual mortality experience of the company.
policy loan An advance, secured by the cash value of a whole life insurance policy, made by an insurer to the policyholder.
renewability A term life policy provision allowing the insured to renew the policy at the end of its term without having to show evidence of insurability.
risk assumption The choice to accept and bear the risk of loss.
risk avoidance Avoiding an act that would create a risk.
Social Security survivor’s benefits Benefits under Social Security intended to provide basic, minimum support to families faced with the loss of a principal wage earner.
straight term policy A term insurance policy written for a given number of years, with coverage remaining unchanged throughout the effective period.
term life insurance . Insurance that provides only death benefits, for a specified period, and does not provide for the accumulation of cash value
underwriting The process used by insurers to decide who can be insured and to determine applicable rates that will be charged for premiums.
universal life insurance Permanent cash-value insurance that combines term insurance (death benefits) with a tax-sheltered savings/ investment account that pays interest, usually at competitive money market rates.
variable life insurance Life insurance in which the benefits are a function of the returns being generated on the investments selected by the policyholder.
whole life insurance Life insurance designed to offer ongoing insurance coverage over the course of an insured’s entire life.
Insuring Your Life Chapter Outline Learning Goals I. Basic Insurance Concepts A. The Concept of Risk 1. Risk Avoidance 2. Loss Prevention and Control 3. Risk Assumption 4. Insurance B. Underwriting Basics II. Why Buy Life Insurance? A. Benefits of Life Insurance B. Do You Need Life Insurance? III. How Much Life Insurance is Right for You? Step 1: Assess Your Family's Total Economic Needs Step 2: Determine What Financial Resources Will Be Available After Death Step 3: Subtract Resources from Needs to Calculate How Much Life Insurance You Require Needs Analysis in Action: The Roberts Family 1. Financial Resources Needed After Death (Step 1) 2. Financial Resources Available After Death (Step 2) 3. Additional Life Insurance Needed (Step 3) E. Life Insurance Underwriting Considerations IV. What Kind of Policy is Right for You? A. Term Life Insurance 1. Types of Term Insurance a. Straight Term b. Decreasing Term Advantages and Disadvantages of Term Life Who Should Buy Term Insurance? B. Whole Life Insurance 1. Types of Whole Life Policies a. Continuous Premium b. Limited Payment c. Single Premium Advantages and Disadvantages of Whole Life Who Should Buy Whole Life Insurance? C. Universal Life Insurance Advantages and Disadvantages of Universal Life Who Should Buy Universal Life Insurance? D. Other Types of Life Insurance 1. Variable Life Insurance 2. Group Life Insurance 3. Other Special-Purpose Life Policies V. Buying Life Insurance A. Compare Costs and Features B. Select an Insurance Company C. Choose an Agent VI. Key Features of Life Insurance Policies A. Life Insurance Contract Features 1. Beneficiary Clause 2. Settlement Options 3. Policy Loans 4. Premium Payments 5. Grace Period 6. Nonforfeiture Options 7. Policy Reinstatement 8. Change of Policy B. Other Policy Features C. Understanding Life Insurance Policy Illustrations Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
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