Chapter 8 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 *Concept Check* II. Why Buy Life Insurance? A. Benefits of Life Insurance B. Do You Need Life Insurance? *Concept Check* III. How Much Life Insurance is Right for You? A. Step 1: Assess Your Family's Total Economic Needs B. Step 2: Determine What Financial Resources Will Be Available After Death C. Step 3: Subtract Resources from Needs to Calculate How Much Life Insurance You Require D. Needs Analysis in Action: The Meese 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 *Concept Check* IV. What Kind of Policy is Right for You? A. Term Life Insurance 1. Types of Term Insurance a. Straight Term b. Decreasing Term 2. Advantages and Disadvantages of Term Life 3. Who Should Buy Term Insurance? B. Whole Life Insurance 1. Types of Whole Life Policies a. Continuous Premium b. Limited Payment c. Single Premium 2. Advantages and Disadvantages of Whole Life 3. Who Should Buy Whole Life Insurance? C. Universal Life Insurance 1. Advantages and Disadvantages of Universal Life 2. 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 *Concept Check* V. Buying Life Insurance A. Compare Costs and Features B. Select an Insurance Company C. Choose an Agent *Concept Check* 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 *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Insure Your Life! Critical Thinking Cases 8.1 Ya Gao’s Insurance Decision: Whole Life, Variable Life, or Term Life? 8.2 The Nisbits Want to Know: How Much Is Enough? Money Online! Major Topics A key ingredient of every successful personal financial plan is adequate life insurance coverage. The overriding purpose of life insurance is to protect the family from financial loss in the event of the untimely death of an income earner. Additionally, some types of life insurance also possess attractive investment characteristics which can further enhance a financial plan if they are chosen correctly. In essence, life insurance is an umbrella for a personal financial plan. The major topics covered in this chapter include: 1. Adequate life insurance acts as protection for the financial goals you have already achieved, and it can also help to attain unfulfilled financial goals. 2. Insurance is based on the idea of recognizing and sharing risk, which includes ways of decreasing risk through loss prevention and control and risk avoidance. 3. The amount of life insurance coverage needed can be determined by assessing your family's needs, subtracting from that amount the resources that will be available after death, and funding the difference. 4. There are three basic types of life insurance policies, which differ from each other by the amount of insurance coverage versus savings element per dollar of premium: term, whole life, and universal. 5. Policy provisions in life insurance policies are very flexible and provide many options to the policyholder and policy beneficiaries. 6. The best coverage for your purposes means that you consider buying the proper amount and right type of insurance as well as the lowest cost for your needs. Key Concepts The key concepts associated with life insurance represent the language of the industry and are used to signify the importance that life insurance represents to the financial security of the insured and his or her beneficiaries. The following phrases represent the key concepts stressed in this chapter. 1. Insurance planning 2. Concept of risk 3. Risk avoidance, risk assumption, and loss prevention and control 4. Underwriting 5. The multiple earnings approach and the needs approach 6. Term insurance: straight and decreasing; renewability and convertibility 7. Whole life insurance: continuous premium, limited payment, and single premium 8. Cash value 9. Universal life 10. Variable life insurance, joint life and survivorship insurance, credit life insurance, group life insurance, and other types of life insurance 11. Contract features of policies 12. Beneficiary clause 13. Settlement options 14. Policy loans 15. Premium payments and grace periods 16. Nonforfeiture options 17. Policy Reinstatement 18. Change of Policy 19. Living Benefits 20. Insurance company ratings 21. Choosing a company and choosing an agent Answers to Concept Check Questions 8-1. Basically, insurance is needed to protect you from losing assets you have already acquired and to shield you from an interruption in your expected earnings. Insurance lends a degree of certainty to your financial plans. Life insurance is meant to replace income that you would have earned had premature death not occurred. Enough life insurance means that family financial plans can be achieved, even though family income might be interrupted. 8-2. a. Risk avoidance involves avoiding the act that creates the risk. It is an attractive way to deal with risk when the estimated cost of avoidance is less than the estimated cost of exposure, although it is not always possible to avoid some risks. b. Loss prevention is an activity (such as obeying the traffic laws) that reduces the probability that a loss will occur. c. Loss control is an activity (such as wearing safety belts in a car) that lessens the severity of an injury or loss once an accident occurs. d. Risk assumption involves bearing or accepting risk. It can be an effective way to handle many types of potentially small exposures to loss for which the protection of insurance would be too expensive. e. With an insurance policy, the policyholder is transferring the risk of loss to the insurance company. You pay an insurance premium in return for a promise from the insurance company that they will reimburse you if you suffer a loss covered by the insurance policy. These concepts are interrelated in that they are all ways of handling the risk of economic loss. Using each method effectively and in connection with one another will help you protect yourself in the most cost effective manner. 8-3. Underwriting is the process by which insurance companies evaluate applications to decide which exposures to loss they can insure and the appropriate rates to charge. Underwriting helps the company guard against adverse selection and establish rates commensurate with the chance of loss. Factors a life insurance underwriter considers include age, sex, occupation, health history and prior problems, driving record and credit rating. 8-4. In addition to financial protection for one's family, the benefits of purchasing life insurance include the following: Protection from Creditors—The purchase of life insurance can be structured in such a way that when death benefits are paid, the cash proceeds do not become part of the estate and, therefore, are protected from creditors. Even if creditors are successful in securing judgments against persons while still alive who have substantial accumulations of life insurance cash values, they most often cannot levy any claim on those cash values. Tax Benefits— Upon the death of the insured, the proceeds of a life insurance policy pass to the beneficiaries free of any state or federal income tax but may have certain death taxes levied, depending on who owned the policy at the time of death. In policies which build cash value, the cash accumulation grows tax free unless it is withdrawn from the policy. If cash values are withdrawn from a policy, income taxes are payable on the amount by which the cash value exceeds the total premiums paid. Vehicle for Savings—Life insurance can be an attractive medium for savings for some people, particularly those seeking safety of principal. Because life insurance companies have a fairly low failure rate, whole and universal life insurance policies are considered very low risk savings media. As investment vehicles, these policies tend to stack up fairly well when their returns are compared to savings accounts, money fund yields, and returns on T-bills—especially when you factor in the tax shelter provided by the life insurance products. 8-5. Reasons people need life insurance are: to provide for those who depend on the insured's income, to eliminate debts, to pay for final expenses, and/or to leave someone a gift. Unless a single college student has one or more of these needs, he or she does not need life insurance. Those college students with student loans, auto loans, or other types of debt would want life insurance to eliminate those debts. Important events such as marriage, birth of children, divorce, etc., call for careful consideration as to life insurance needs. Of particular importance is the birth of a child, which instantly creates a long-term need for a large amount of life insurance. 8-6. The two basic methods for determining a person's life insurance requirements are the multiple earnings approach and the needs analysis approach. The multiple earnings approach is a simple technique in which the amount of insurance to purchase is found by multiplying gross annual earnings by some arbitrarily selected number. Most frequently multiples of five, or in some cases, ten, are used. The needs analysis approach considers the financial resources available in addition to life insurance and the specific financial obligations that a person may have. It involves three steps: (1) Estimating total economic resources needed; (2) Determining all financial resources that would be available after death; and (3) Subtracting the amount of resources available from the amount needed to determine the amount of life insurance required to provide for an individual's financial program. 8-7. The most common economic needs that must be satisfied after the death of a family breadwinner are: funds to pay off debts in order to leave his or her family relatively debt-free; income to sustain the family until the children are self-sufficient; income to sustain in full or part the surviving spouse; and income to fund any special financial requirements, such as college education for children and/or surviving spouse. Using the needs approach, each of these financial needs should be estimated and viewed in light of available resources to determine life insurance requirements. 8-8. Factors a life insurance underwriter considers include age, sex, occupation, health history and prior problems, driving record and credit rating. The company is trying to determine the likelihood of their having to pay a claim if they issue you a policy. 8-9. Under the provisions of term life insurance, the insurance company agrees to pay a stipulated sum if the insured dies during the policy period. Common periods of coverage are five years, ten years, even thirty years with premiums payable annually, semiannually or quarterly. Term insurance offers the most economical way to purchase life insurance on a temporary basis for protection against financial loss resulting from death, especially in the early years of family formation. Common types of term life insurance include: Straight Term—the most frequently purchased, it is a term policy written for a given number of years. The face value of the policy remains constant while the cost of the insurance increases along with one’s risk of mortality. With annual renewable term policies, the annual premiums increase each year reflecting one’s increased likelihood of dying each year. With level-premium term policies, the premiums remain constant for a specified period of years. The cost of insurance still increases each year, but with level-premium policies, the costs for the given period are averaged so that for the first few years of the policy, the insured is overpaying for the cost of insurance, and for the last few years, he or she is underpaying. Decreasing Term—a term policy that maintains a level premium throughout all periods of coverage, while the face amount decreases. As the insured gets older, the cost of insurance goes up reflecting the greater chance of death occurring. If the premium remains constant but the cost is increasing, then the amount of coverage has to decrease. This type policy is often used to provide for mortgage or other debt repayment in the event of death. The face amount decreases along with the amount of outstanding debt. In addition, term insurance is often written with renewability and convertibility provisions. The first provision basically allows the insured to renew his or her policy for another term without providing proof of insurability; in contrast, the second provision allows the insured to convert his or her policy to whole life without providing proof of insurability. 8-10. The primary advantage of term life insurance is that it offers an economical way to purchase a large amount of protection against financial loss resulting from death, especially during the childbearing years. The guaranteed renewable and convertible options allow the insured to continue coverage throughout his or her life. The most commonly cited disadvantage of term insurance is that the rates increase as the insured ages. People frequently discontinue coverage for this reason. 8-11. Whole life insurance is designed to offer financial protection for the entire (whole) life of an individual, and the premiums are calculated assuming lifetime protection for the insured. (Term life insurance premiums are calculated based on the probability of death during the given time of the term only.) In addition to death protection, whole life insurance has a savings element called cash value. The life insurance company sets aside assets to be used to pay the claims expected to result from the policies they issue. If policyholders decide to cancel their contracts prior to the death of the insured, that portion of the assets set aside to provide payment for the death claim which did not take place is available to them for use in their retirement years, for example. Whole life policies, therefore, either pay accumulated cash values to the policyholder if canceled or pay their face value to the beneficiaries at the death of the insured. 8-12. State laws require that permanent whole, universal, or variable life policies contain a nonforfeiture provision. With the paid-up insurance provision, the policy holder receives a policy exactly like the terminated policy, but with a lower face value. In other words, the cash value buys a new single premium policy and allows the policy holder to still have some coverage. This also makes reinstatement of the original policy possible if the policy holder pays all back premiums plus interest and can meet any insurability requirements. 8-13. The three major types of whole life policies, based on premium frequency, are: 1) Continuous premium whole life policies, which require a level premium payment each year until the insured dies. 2) Limited payment whole life policies, which offer coverage for the entire life of the insured but schedule the payments to end after a limited period. The period may be a stated number of years, such as 20-year life, or until a specified age, such as paid-up at age 45. 3) Single premium whole life policies, which are purchased on a "cash basis." One premium payment upon inception of the contract buys life insurance coverage for the insured for the remainder of his or her life. One advantage of whole life is that the premium payments contribute toward building an estate, regardless of whether the insured lives or dies. It also permits individuals who need insurance for an entire lifetime to budget their premium payments over a relatively long period, thus eliminating the problems of affordability and uninsurability often encountered in later years with term insurance. Disadvantages most often cited are that more death protection for the same amount of money can be purchased with term insurance and higher yields can be obtained on other investments. 8-14. Universal life insurance is a blended product that combines the features of an investment that earns current money market interest rates with a term life insurance policy. It offers policyholders a product that blends the favorable features of a whole life policy with the higher yields that money market and bond funds pay. Universal life insurance is a type of whole life insurance because the policy provides both death protection and a savings element. However, unlike whole life, universal life separates the insurance protection portion from the savings portion and offers the insured greater flexibility in paying premiums and in changing the level of the benefit. You can increase or decrease both your premium payments and death benefits as long as there is currently enough to pay the cost for the death protection element. Variable life is like universal life in that a death benefit provision is combined with a savings/investment plan. The big difference is that the consumer can select and periodically change the type of investment vehicle—money market funds, bond funds, and even stock funds—used with his or her variable life policy. Another difference between variable life and whole or universal life is that the amount of death benefits provided will vary with the profits (or losses) generated in the investment account. 8-15. Group life insurance is an arrangement under which one master policy is issued, and each eligible member of the group receives a certificate of insurance. It is nearly always term insurance, and the premium is based on the characteristics of the group as a whole rather than those related to any specific individual. Group insurance is commonly offered as a fringe benefit to employees. Because of its temporary nature and relatively low face amount (often equal to one year's salary or less), it should fulfill only low-priority insurance needs. However, the employee may be allowed to purchase additional insurance for himself as well as his dependents. This is a very attractive feature when employees intend to stay with the same employer for an extended period. For individuals and their dependents who may be virtually “uninsurable” because of health problems, etc., this may be about the only way they can obtain insurance. 8-16. a. Credit life insurance assures the borrower's beneficiaries that, upon death of the borrower, the stated debt will be repaid. Most often this type of insurance is a term policy with a face value that decreases at the same rate as the balance on the loan and is one of the most expensive ways to buy life insurance. Contrary to popular belief, a lender cannot legally reject a loan if the potential borrower chooses not to buy credit life insurance from them. b. Mortgage life insurance is a form of credit life designed to pay off the mortgage balance upon the death of the borrower. This need can usually be met less expensively by shopping the open market for a suitable decreasing term policy. The high cost of mortgage life insurance is attributable to the fact that the lender selling such insurance receives a commission, and, therefore, is not sensitive to cost factors. c. Industrial or home service life insurance is whole life or endowment insurance issued in policies with small face values and is sold by agents who call on policyholders weekly or monthly to collect the premiums. The small size of its policies coupled with the high collection costs makes this insurance more expensive per dollar of coverage than whole life or endowment policies. It is rarely sold and accounts for less than 1% of the total amount of life insurance in force in the U.S. 8-17. The first and most important step involved in shopping for and buying life insurance is developing an estimate of your future financial needs and then selecting the types of policies that will best satisfy those needs. Life insurance must be evaluated in conjunction with other financial goals. A person should also become familiar with the various provisions that life insurance contracts typically include. Next, a person should select companies and agents to contact based on their reputations (financial and otherwise), cost of their policies, and agents' experience, training, and personality. Once these decisions have been made, the individual(s) should discuss their needs with their agent and capitalize on his or her expertise. They should learn the details of the various policy alternatives and select the most cost-effective policy that best serves their coverage needs. 8-18. A.M. Best, Moody's, Fitch, and Standard & Poor's all rate insurance companies according to their underlying financial strength. These firms look at the financial solvency of insurance companies and assess the ability of the insurer to pay future claims to their policyholders. They look at the insurance company's investment portfolio (especially its holding of high risk real estate and junk bonds), its debt structure and the adequacy of its capital to absorb financial shocks, and even its pricing practices and management strategies. From such in-depth analysis, the rating agencies then assign letter ratings that designate the financial integrity of the insurance company—the higher the rating, the more financially secure the company. Obviously, it is important to know how an insurance company is rated (financially) because you are depending on them to stand behind a very sizable financial obligation (a life insurance policy that could easily run into six figures) at some unknown time in the future. Because of this, you would probably want to stick with insurance companies that receive one of the top two or three grades from the rating agencies (A++ to A from Best; Aaa to Aa2 from Moody's; and AAA to AA from S&P); equally important, look for companies that receive one of these top grades from all of the major rating agencies. 8-19. Important factors to consider in choosing an insurance agent include his or her level of competence, knowledge of the insurance industry and the various insurance products, willingness to listen to you and his or her attentiveness in determining the most appropriate insurance products to meet your needs. You also want an agent who is known to be dependable and capable of working with other professionals in carrying out your insurance planning needs. 8-20. A beneficiary is the person or persons who receive the death benefits of the policy if the insured person dies. A contingent beneficiary is a person or persons to whom benefits of the policy would go in the event that the insured outlives the primary beneficiary or that they both died at the same time. It is essential to name a beneficiary. Otherwise, the policy proceeds would be payable to the estate of the deceased and might be subject to prolonged legal and other procedures associated with estate settlement. 8-21. There are five basic settlement options available for payment of life insurance proceeds upon the death of the insured. Lump sum—The entire death benefit is paid to the beneficiary in a single amount. Interest Only—The policy proceeds are left on deposit with the insurance company for a given period of time. In exchange, the insurer guarantees to make interest payments to the beneficiary during the time it holds the funds. The beneficiary may or may not be permitted to withdraw the proceeds, depending on the agreement. Fixed period payments—The face amount of the policy, along with earned interest, is systematically liquidated over a fixed period of time. The amount of the periodic payment is determined by the face amount of the policy and length of time over which the funds are to be distributed. Fixed amount payments—The beneficiary chooses the amount of periodic benefit desired rather than the number of years over which income is to be received. The period over which the payments are received will, therefore, be determined by the amount of policy proceeds and the size of the periodic benefit specified by the beneficiary. Life Income—The insurer guarantees a certain payment amount to the beneficiary for the remainder of his or her life. The amount is dependent upon the face value of the policy, interest rate assumptions, and the life expectancy of the beneficiary. 8-22. With policies which build cash value, policyholders have a right to receive the cash value if they cancel their policies prior to death (i.e., they do not have to forfeit their cash value). Nonforfeiture options give policyholders choices concerning how they wish to receive these benefits in the event that they do cancel their policies. One option, of course, may be to receive cash. With the paid-up insurance option, the policy's cash value is applied to a new, single-premium policy with a lower face value. Under the extended term insurance option, the cash value is used to buy a term life policy of the same face value; the coverage period is based on the amount of term protection that can be purchased for the given amount of cash value for a person of the insured's age. 8-23. a. A multiple indemnity clause doubles or triples the face amount of a policy if the insured dies as a result of an accident. This benefit is usually offered to the policyholder at a small additional cost. b. A disability clause may contain either a waiver of premium benefit or a waiver of premium 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). Under the disability income portion, the insured is entitled to a monthly income equal to five or ten dollars per $1,000 of policy face value. Some policies will continue these payments over the life of the insured; others will terminate them at age 65. c. A suicide clause voids the contract if an insured commits suicide within two years (sometimes one) after its inception. In such cases, the company returns the premiums that have been paid. If the insured takes his or her life after this initial period has elapsed, the policy proceeds are paid without question. The most common exclusions are aviation (piloting a private plane or flying on a military plane) and war. Hazardous occupations or hobbies, such as skydiving, may also be specifically excluded. 8-24. With a participating life insurance policy, the policyholder is entitled to receive policy dividends that reflect the difference between the premiums that are charged and the amount of premium necessary to fund the actual mortality experience of the company. A company estimates its base premium schedule and then adds an adequate margin of safety. The premiums charged to the policyholder are based on these somewhat overcautious estimates. When the company experience is more favorable than that estimated, policyholders receive policy dividends. The policyholder may accept the dividend as a cash payment, leave it with the company to earn interest, use it to buy additional paid-up coverage, or apply it toward the next premium payment. 8-25. When you look at an insurance illustration, focus first on the basic assumptions and double check all information. Ask the insurance agent to provide an inforce reprojection that shows any changes in credits or charges that the insurance company has declared for the next policy year. These changes will affect your premiums or benefits. Watch for any unexpected premium changes or increases. Check for the following parts of the illustration to make sure that all changes are present and that you understand their contents: • Policy, description, terms and features; • Underwriting discussion; • Column definitions and key terms; • Disclaimer; and • Signature page. Financial Planning Exercises 1. Worksheet 8.1 for Rachel Ehrlich follows. Because Rachel needs a considerable amount of coverage while her mother is still alive, she should buy a term policy with level premiums for at least 15 years, or even better, 20 years. The premiums on annual renewable term will become increasingly more expensive for Rachel, so she would want to lock in a lower level premium at least during her mother's life expectancy. She would want to decrease her coverage to an amount that would cover her debts and final expenses if her mother dies prior to maturity. Rachel should immediately see if she can get a long-term care policy for her mother. Her mother is likely to need nursing home care regardless of whether Rachel is alive or not, and the cost of providing that care will take up almost all of Rachel’s income. Unfortunately, such policies become more expensive the older the person, and with her mother's health problems, she may not even be able to get a policy now. If Rachel can get a policy for her mother now, she would probably be better off working a second job to pay the high premiums than be near destitute when her mother's health deteriorates. Problem 1—Worksheet 8.1 2. Students' answers will vary. Undergraduates will probably not need insurance unless they have dependents. Older students should justify their answers. 3. Worksheet 8.1 for Adam Modine follows. Given his current circumstances, he should consider purchasing additional life insurance. With child support and alimony, he is paying $22,800 per year to support his family. Because his ex-wife doesn't make very much in her job, if he were to die prematurely, his children would suffer. The younger child is only 7, so it will be at least 15 years until that child is through college. The illustration shown assumes that Adam will continue his current level of support until the younger child reaches age 22. Although the problem does not mention an amount dedicated for his children’s college costs, which is commonly part of a divorce settlement, Adam should consider establishing a college fund. The cost of college is bound to rise during that time period. Currently, Adam makes enough money that if he is alive, he will be able to contribute more for their college expenses. If he were to die prematurely, his children would receive his savings and retirement assets, which hopefully will be increasing regularly through time. [Adam should, however, name a trustee to administer the assets for the benefit of his children while they are still minors.] Problem 3—Worksheet 8.1 Adam is already in his 40s, so the cost of term insurance is not as affordable as it would be for someone younger. He also needs to think ahead for his retirement needs, and his current $100,000 will not be enough. He might consider a variable life insurance policy in which he can build some cash value that he could use for his own needs if he so chooses. He would be able to direct how the cash value is invested and would hopefully get a better return than on whole life insurance. In fact, he could get two policies—one a decreasing term policy with level premiums for the next 15 years and the other a variable policy for growth and for his own needs later. The decreasing term policy would be cheaper than a straight term policy, and it would be appropriate because his life insurance coverage needs should decrease as his other investments grow through time. Adam might want to find a good financial planner to help him at this juncture point in his life to plan not only for his children's needs but also for his own retirement needs. 4. The premium calculations 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. However, remember that whole life insurance builds up cash value, so that if the insured canceled the policy, he or she would receive the cash value back (subject to any taxes and possibly a penalty if withdrawn before age 59 1/2). With term life insurance, there is no cash value build up and the premiums are simply gone. We cannot adequately compare the true costs of these policies without having the schedule for the whole life policies' cash value build up over the specified time periods. [Note: Exhibit 8.2, Annual Renewable Term (ART) Life Premiums, is condensed and only shows years 1 and 5; in reality, the premium will increase each year. One approach to estimate the five- or ten-year cost is to develop an annual average based on the first and last years of the coverage period in question, the method used here. The instructor may prefer to skip ART and have students compare only level premium term and whole life.] Premium Comparisons for 5-Year Period, Age 25, $100,000 coverage: ART premium calculations: Year 1 + Year 5 = average annual premium 2 Male: $95 + $97 = $96 Female: $49 + $63 = $56 2 2 Multiply annual premiums by 5 to get total premiums paid over a 5-year period. Annual Renewable Term: Level-Premium Term: Whole Life: Premiums: Annual 5-Yr. Total Annual 5-Yr. Total Annual 5-Yr. Total Male $96 $480 $106 $530 $603 $3,015 Female $56 $280 $102 $510 $525 $2,625 Premium Comparisons for 10-Year Period, Age 40, $100,000 coverage: ART premium calculations: Year 1 + Year 10 = Average annual premium 2 Male: $145 + $237 = $191 Female: $117 + $194 = $155.50 2 2 Multiply annual premiums by 10 to get total premiums paid over a 10-year period. Annual Renewable Term: Level-Premium Term: Whole Life: Premiums: Annual 10-Yr. Total Annual 10-Yr. Total Annual 10-Yr. Total Male $191 $1,910 $122 $1,220 $1,078 $10,780 Female $155.50 $1,555 $115 $1,150 $931 $9,310 5. A comparison of the differences in costs for Lilia over a 20-year period is shown below. The representative tables given in the text as Exhibits 8.2 and 8.3 were used to estimate the cost of annual renewable term and level premium term rates—actual costs will vary. The annual premium of $1,670 for $250,000 of whole life insurance coverage was given in the problem. Premium Comparisons for 20-Year Period, Age 25, $250,000 coverage: ART premium calculations: Year 1 + Year 20 = Average annual premium 2 Female: $49 + $151 = $100 per $100,000 × 2.5 = $250 for $250,000 coverage 2 Multiply annual premiums given for $100,000 coverage by 2.5 to get annual premiums for $250,000. Then multiply annual premiums for $250,000 coverage by 20 to get total premiums paid over a 20-year period. Annual Renewable Term: Level-Premium Term: Whole Life: Premiums: Annual 20-Yr. Total Annual 20-Yr. Total Annual 20-Yr. Total Female $250 $5,000 $290 $5,800 $1,670 $33,400 Term life would be more affordable for a young family because it costs much less than whole life insurance. However, the whole life policy would build up cash value over time and would serve as a means of forced savings against which the family could borrow against if needed. Without knowing the specifics of the policy, it is difficult to estimate how much cash value would build up over the next 20 years. And bear in mind that because the policy assumes an earnings rate of 5% per year, there is no guarantee that the policy will in fact earn 5%. Before Lilia buys any policy, the family must evaluate its insurance needs to determine if $250,000 is the right amount and how much they have to spend for premiums. They also should determine if more insurance is needed on Mateo. Then they can choose the type of policy. They may be better off with term insurance and investing the difference in premiums; this would also provide greater financial flexibility for a young family. Some things to consider in making their decision: a. Most young families simply don’t have the extra money to sink into whole life policies. b. The whole life policy may not earn 5%—they typically guarantee a very low rate while assuming a higher rate in savings illustrations. c. Lilia’s investments could yield greater than the assumed rate if the family bought term and invested the difference in premium amounts. d. What about getting the 20-year level term and placing the difference in premiums in a Roth IRA? This would provide a tax-sheltered growth environment and greater flexibility as the principal (not the earnings) can be tapped anytime without penalty. She would also be providing for her retirement as well. e. True, loans can be taken out against the cash value of whole life policies, but there are consequences in doing so. If the money is not repaid, income taxes must be paid on the loan amount plus possible penalties. If the insured dies with an outstanding loan, this amount is subtracted from the amount the beneficiaries receive. 6. The returns on variable life insurance policies are not guaranteed, so this policy may not provide the anticipated level of savings. Also, this form of life insurance typically has high expenses and annual fees that reduce overall returns, so he should shop carefully. If your coworker wishes to borrow against the cash value in the policy to pay for his child's college education, there are consequences to doing so. As mentioned in the problem above, if the loan is not repaid, income taxes must be paid on the loan amount plus possible penalties. If the insured dies with an outstanding loan, this amount is subtracted from the amount the beneficiaries receive. As for buying additional term insurance through a group plan, the insured needs to compare the group premiums with those from other insurance companies to find the most cost effective coverage. Make sure this coworker knows that term insurance does not build cash value, so taking out a loan against the policy is not an option. Also, what would happen to her coverage if she were to change employers? Point out that the older you get, the more expensive term insurance becomes. If she feels she will need insurance later on in life, she might want to find a good whole life or variable life policy now that builds cash value. Solutions to Critical Thinking Cases 8.1 Ya Gao’s Insurance Decision: Whole Life, Variable Life, or Term Life? 1. a. Whole life insurance provides protection over the whole life of the insured. In addition to death protection, whole life insurance has a savings element called cash value, which results from the manner in which premiums are paid. b. Variable life insurance allows the policyholder to decide how the money in the cash value component should be invested. Therefore, it offers the highest and most attractive level of investment return, but it also involves the most risk, because unlike whole or universal life, no minimum return is guaranteed. It also tends to have higher expenses and fees. c. Term insurance is a type of life insurance under which the company agrees to pay a stipulated amount if the insured dies within the policy period. It offers the most economical way to purchase life insurance on a temporary basis. This form of life insurance only offers protection against financial loss resulting from death. It has no savings function. 2. The major advantages of whole life are: (1) building an estate as the cash value accumulates or as the face value is paid upon death; (2) the premium is constant over a lifetime, so if you need lifetime insurance the premiums are known; (3) it provides a regular forced savings feature that many people like; (4) the cash value can be borrowed against; and (5) the accumulated earnings are given favorable tax treatment. The most frequently cited disadvantages of whole life are that: (1) more death protection can be purchased with term insurance; (2) higher yields may be obtained from other investment vehicles; and (3) there may be consequences to borrowing against the cash value. The major advantages of variable life include: (1) the ability to spread your money over a variety of different investment accounts in one convenient, tax-favored package; (2) the ability to move funds from one account to another as market conditions dictate; and (3) the tax benefits, which include earnings free of current taxation, no tax consequences to switching between funds, and a tax-free death benefit. The major disadvantages are: (1) you can lose money on the investment portion, which could reduce (or possibly even wipe out all together) the built-up cash value and (2) the amount of insurance protection is not well defined because it depends, in large part, on the amount of profits or losses generated from your investments—in other words, you may end up with a lot less insurance coverage than you want. The major advantage of term insurance is that it offers an economical way to purchase a large amount of life insurance protection over a given, short period of time. The major disadvantage is that the cost of continued term coverage will increase through time due to the increased chance of death as one gets older. Therefore, people frequently discontinue needed coverage because of increasing cost. 3. Whole life is superior to variable life because it emphasizes the insurance element of the policy and guarantees a minimum earnings level. Whole life is superior to term in that the premium is constant over a long period of time so that both the level of insurance and the amount of the premium are known. Variable life is superior to whole life because of the better investment earnings opportunities and is superior to term because of this savings element. Term is superior to both whole life and variable life because of its emphasis on the insurance element. The highest face value per dollar of premium is available with term. 4. Ya should probably buy some form of term insurance. As a single parent with young children, she needs to get the most coverage possible per dollar expended. She also needs to supplement the insurance provided by her employer with other insurance that is not dependent on her job security. The $150,000, 25-year limited payment whole life policy might not be feasible due to its high premium cost per dollar. These high rates are due to the large savings component that results because the policy will be fully paid up after only 25 years. If whole life were chosen, continuous premium whole life would more affordable. Variable life insurance would not be appropriate at this time, as she needs to have a known amount of coverage in order to provide for her three children. Since Ms. Gao’s goal is to obtain as much coverage per dollar as possible, rather than building sizable savings, she should purchase term insurance. If she wants to continue the term coverage beyond its initial maturity, she may want to consider some type of renewability provision. A good choice might be to lock in the rate of a 20-year level term policy, and by that time hopefully the last child will be through college. A convertibility option may also be desirable so that as her needs change from pure insurance coverage to saving for retirement, she can shift from term insurance to some type of whole life insurance. Regardless of the options she selects, term insurance will probably best fulfill her insurance needs at this point in her life. 8.2 The Nisbits Want to Know: How Much is Enough? 1. Using the earnings multiple calculation, the Nisbits’ insurance needs are: Ryan: $54,000 × 8.7 = $469,800 Alison: $64,000 × 7.4 = $473,600 2. Worksheet 8.1 for both Ryan and Alison are found on the following pages. Note that the first worksheet is for Ryan Nisbit; this was prepared to show the needs that will exist if Alison dies and Ryan is the surviving spouse. The second worksheet is for Alison Nisbit, and here it is assumed Alison is the surviving spouse. The worksheets show that Ryan needs another $460,000 in life insurance, while Alison should have another $330,000. Ryan’s life insurance needs are less because Ryan makes more money, and as the surviving spouse, she can provide a larger share of the family's income needs. 3. The amount of insurance needed is different depending on the methods used in questions 1 and 2. The earnings multiple approach from question 1 is a general, average estimate of a family's needs; the worksheets in question 2 address the Nisbits’ specific situation. The needs approach gives a far more accurate picture of life insurance needs and also considers existing life insurance and other assets. Using the Needs Approach in number 2 above, we found that Ryan needs another $480,000 in life insurance and Alison needs another $310,000. However, the $100,000 amount they now have is a declining-term policy, which means every year the payoff amount decreases. This policy may not be very cost effective, and they may be better off replacing it, particularly since their insurance needs will increase each year because this policy will pay less and less. Therefore, they would probably do well to get an additional $600,000 of insurance for both of them, and after it is in place cancel the declining-term policy. [This problem is continued after the worksheets.] Case 8.2, Problem 2—Worksheet 8.1 Case 8.2, Problem 2—Worksheet 8.1 Annual renewable term is usually not as cost effective as a level term policy. If the Nisbits are considering a term policy, they would probably be better off with a 20-year level term policy rather than annual renewable term. (A 20-year time frame was chosen because that is about how long it will take for the youngest child to finish college.) If they would like a policy which builds cash value, whole life would probably be better for them than either variable or variable universal life. Because their children are young, they need to have a policy where they know what the payoff amount will be. Such is not the case with either of the variable policies. Universal life might be an attractive option to whole life. However, we will consider the options of 20-year level term and whole life insurance, as we do not have an example table of premiums for universal life insurance. The following chart compares the premiums on a 20-year level term policy with a whole life policy. The representative tables given in text Exhibits 8.3 and 8.5 were used. Actual costs will vary. Premium Comparisons for 20-Year Period, Age 35, $200,000 coverage: Multiply annual premiums given for $100,000 coverage by 2 to get annual premiums for $200,000. Then multiply annual premiums for $200,000 coverage by 20 to get total premiums paid over a 20-year period. Level-Premium Term: Whole Life: Premiums: Annual 20-Yr. Total Annual 20-Yr. Total Male $268 $5,360 $1,782 $35,640 Female $250 $5,000 $1,550 $31,000 Total for both $518 $10,360 $3,332 $66,640 The 20-year level term is obviously more affordable, costing only $518 per year vs. $3,332, a difference of nearly $3,000. Clearly, the Nisbits have to decide if they can even afford the whole life insurance. The difference in premiums paid over a 20 year period is even more dramatic, with the whole life costing over $100,000 more than the level term. However, the whole life would have built up a cash value of $36,750 × 2 = $73,500 for a $200,000 policy after 20 years for 2 people. So, the Nisbits would have to decide if they could better invest this money or if the whole life should be viewed as protection plus an investment. In the case of the term insurance premiums, the amounts paid would just be gone. If the Nisbits have the money to pay the premiums on the whole life policy, then they have to decide if they would be better off getting the level term policy and investing the difference. The whole life policy would allow their investment to grow tax free, which is a plus. However, if the Nisbits ever need to take a loan against their life insurance and don’t replace it in a given time period, they will have to pay taxes and possibly a penalty. One attractive choice would be to invest as much as is allowed of the difference in yearly premiums in Roth IRAs each year. Their money would grow tax free and offer the family more flexibility in using their money for their children’s education if necessary. The remainder of the annual difference would be invested in a taxable account. It is possible that the family's investments after 20 years would be more than what the cash value would be on whole life insurance. And, if they remove cash value from a whole life insurance policy, some amount would be lost to taxes. Plus, the Roth IRAs would provide tax-free income for their retirement. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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