The Role of Life and Health Insurance

1
Chapter 9

• The Role of Life and Health Insurance

2
Understanding the Logic Behind Insurance

• Insurance is an example of risk pooling --
  individuals share their financial risks to reduce
  catastrophic losses from death, accidents, or
  health problems.

3
Life Insurance Policy Terms

• Premium -- the monthly cost of the policy
• Face value -- the benefit due upon death
• Insured -- the person whose life is covered by
  the policy
• Policy owner -- the individual or business that
  pays for and owns the policy
• Beneficiary -- the recipient of the benefit upon
  the death of the insured

4
Life Insurance May Not Be Necessary for the
Following

• Single person, without dependents
• Double-income married couple, without dependents
• Married, but unemployed, individual without
  dependents
• Retired persons

5
Life Insurance May Be Necessary for Those

• With dependents
• Who are a married, single-income couple, with
  children
• Who are business owners?
• Whose estate exceeds the estate tax-free transfer
  threshold (675,000 in 2000/2001 and increasing
  to 1M by 2006).

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Determine Your Life Insurance Needs Two methods

• The earnings multiple approach
• To replace the annual salary stream of a bread
  winner for X years, normally 5 15 times gross
  salary is recommended.
• The needs approach
• To meet the needs of the household after the
  death of a breadwinner, both current and in the
  future.

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The Earnings Multiple Approach

• Adjust salary down to compensate for the
  reduction in household expenses.
• Choose the PVIFA i, n yr to match the assumed
  after-tax and after-inflation earnings on the
  policy settlement.
• The longer the income stream replacement, the
  greater the multiple. The higher the assumed
  earnings, the lower the multiple.

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Earning Multiple Approach Formula

• Life Insurance Needs
• Income x (1 of income spent on the deceased)
  x PVIFA i, n yr

Assume earning 75,000, less 25,000 for
remaining 30 years at 5 , how much insurance
should one have?
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The Needs Approach -- The Seven Funds

• Immediate needs funds
• Debt elimination funds
• Immediate transitional funds
• Dependency funds
• Spousal life income funds
• Educational funds for child or spouse
• Retirement income funds

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The Needs Approach -- The Calculation

• Add all funding needs to determine total need
• Subtract current insurance coverage and other
  available assets
• This determines amount of additional insurance
  coverage necessary

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Needs Approach

• Bill age 35 and Mary age 33 seek your advice on
  the amount of life insurance to purchase. They
  have two children ages six and four.
• Bill earns 65,000 per year in salary.
• Their home is worth 150,000 and they have a
  90,000 mortgage.
• Their savings and investments total 30,000.
• Mary currently does not work and would find it
  difficult to go to work until the youngest child
  enters first grade in two years.
• She anticipates she could earn 40,000 after
  taxes at that time which would handle all her
  needs throughout her working life.

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Bill and Mary Continued

• Funeral and administrative expenses would
  approximate 10,000.
• The family anticipates a current need of 100,000
  to assist the children with college education.
• Mary acknowledges that she needs an additional
  8,000 per year per child to cover expenses until
  the children are off the nest.
• Assume 45,000 of Bills salary is devoted to the
  family and 8 is an appropriate rate of return.
• How much insurance does Bill need?

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Major Types of Insurance

• Term insurance
• Cash-value insurance

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Term Insurance

• Death benefit coverage for a specific term of
  time
• Only valid if the insured dies during the term of
  coverage
• Least expensive form of insurance

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Cash-Value Insurance

• Provides a death benefit and an opportunity to
  accumulate savings
• Provides permanent insurance

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Types of Cash-Value Insurance

• Whole life insurance for those who need
  permanent life insurance protection
• Universal life insurance for those who want a
  flexible policy that combines term protection and
  tax-deferred savings
• Variable life insurance for those who want to
  take risks and manage their own investments with
  an opportunity for tax-deferred savings.

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Whole Life Insurance and Its Features

• Permanent protection
• Fixed premium
• Fixed death benefit
• Fixed cash-value that grows tax-deferred
• Much less death protection than term for the same
  price
• Yield on cash value portion is not competitive
  with yields on alternative investments

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Universal Life Insurance and Its Features

• Permanent protection
• Flexible premium payments with unbundling
• mortality charge or term insurance
• cash value or savings
• administrative expenses
• Flexible death benefits
• Cash-value fluctuates depending on the amount
  paid into the policy

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Universal Life Insurance and Its Features (contd)

• Returns fluctuate widely
• Policies often lapse because of the flexibility
  to not make premium payments
• Savings may not accumulate as expected due to
  fluctuations in return and high expense charges

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Variable Life Insurance and Its Features

• Permanent protection returns are earned on a
  tax-deferred basis
• Allows for either a fixed (straight variable) or
  flexible (variable universal) premium
• Flexible death benefit and fluctuating cash
  value, reflecting the mutual fund investment
  performance

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Determining Which Type of Insurance Is Right for
You

• For most, term is the best alternative.
• Relatively low cost
• Affordable coverage when life insurance is needed
  the most
• Can afford to carry the coverage needed
• Becomes very expensive with age, but may be
  unnecessary

22
Determining Which Type of Insurance Is Right for
You

• Cash-value insurance offers tax advantages
• Savings grow tax-deferred and are passed on
  without incurring estate taxes
• Other investment plans are better relative to
  cash-value insurance

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1. The Beneficiary Provision

• Allows for the naming of primary and contingent
  beneficiaries.
• May name an irrevocable beneficiary that cannot
  be changed without permission of the beneficiary.

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2. The Grace Period Clause

• Automatic extension of 30 or 31 days that the
  owner has to pay the premium without the policy
  lapsing.

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3. The Loan Clause

• Only exists on policies with a cash value.
• Allows the owner to borrow against the cash value
  of the policy.

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4.The Nonforfeiture Clause

• Provides options for policy holders to terminate
  their policies early
• receive the cash value
• exchange cash value for a paid-up policy with a
  reduced face value
• exchange cash value for a paid-up term policy
  with the full face value

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5. The Policy Reinstatement Clause

• Option for restoring a lapsed policy within 3 to
  5 years of the expiration
• Generally requires all past due premiums, loans,
  and interest be paid before reinstatement

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6. The Change of Policy Clause

• Allows the policy holder to change the type of
  policy in effect

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7. The Suicide Clause

• States that the insurance company will not pay
  death benefits if the insured commits suicide
  within 2 years of when the policy took effect.

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8. The Payment Premium Clause

• Explains the options available for the payment of
  the premiums, such as monthly or annually.

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9. The Incontestability Clause

• Declares that the insurance company can not
  dispute the validity of the policy after a
  certain time period has passed, normally 2 years.
• This clause provides very important protection to
  the beneficiary against policy cancellation.

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10. Settlement Options

• Lump-sum settlement -- one time payout upon death
  of the insured.
• Interest-only settlement -- periodic payments of
  the interest earned by the principal.

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Buying Life Insurance

• 1. Buyer beware -- a little knowledge goes a long
  way
• 2. Select a high-quality insurance company based
  on company ratings
• 3. Select an insurance agent with whom you feel
  comfortable
• 4. Compare costs of competing policies
• 5. Consider alternative approaches the net or an
  advisor

34
Major Types of Health Care Coverage

• Basic health insurance
• Major medical expense insurance
• Dental and eye insurance
• Dread disease and accident insurance

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Basic Health Insurance

• Hospital insurance -- covers hospitalization
  expenses including room fees, nursing fees, and
  drug fees.
• Surgical insurance -- covers only the direct
  costs of surgery including the surgeons fees and
  equipment fees.
• Physician expense insurance -- covers physicians
  fees including office fees, lab fees, and X-ray
  fees.

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Major Medical Expense Insurance

• Covers medical costs beyond the basic plan.
• Normally requires co-payments and deductible
  payments.
• Stop-loss provision -- limits the total
  out-of-pocket expenses incurred by the insured to
  a specific dollar amount.
• Life-time cap -- total amount the insurance
  company will pay over the life of a policy.

See examples in notes
37
Dental and Eye Insurance

• Covers the costs of eye exams, glasses, contact
  lenses, dental work, and dentures.
• Typically prohibitively expensive unless provided
  with an employer plan.

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Dread Disease and Accident Insurance

• Covers only specific illness or accidents.
• Provides a set dollar amount of reimbursement.
• Note Avoid these types of insurance --
  concentrate on making your health coverage as
  comprehensive as possible.

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Private Health Care Plans

• Fee-for-service or traditional indemnity plans
• Managed health care
• health maintenance organizations (HMOs)
• preferred provider organizations (PPOs)

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Fee-for-Service or Traditional Indemnity Plans

• Provides greatest flexibility for choosing
  doctors and hospitals.
• Coinsurance -- defines the percentage of each
  claim that the policy will cover.
• Co-payment or deductible -- defines the amount
  that you must pay before a claim is eligible for
  reimbursement.
• Plans are relatively expensive and require more
  paperwork.

41
Managed Health Care

• Pays for and provides health care services to
  policy holders.
• Limits choices to the doctors and hospitals that
  participate.
• Requires the policy holder to pay a monthly
  premium and share the cost of care.
• Provides the most efficient payment of bills.

42
Group Insurance

• Is sold to a group or employer rather than to an
  individual
• Normally does not require subscribers to pass a
  medical exam
• 15 - 40 cheaper than an individual policy

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Government-Sponsored Health Care Plans

• Workers Compensation
• Medicare
• Medicaid

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Workers Compensation

• Provides insurance to workers injured on the job
• Provides payment for work-related accidents and
  illness
• Coverage is determined by state law and varies by
  state

45
Medicare

• Provides medical benefits to the disabled and to
  those 65 and older
• Cost is covered through Social Security tax
• Divided into two parts -- A and B
• Part A is compulsory and covers hospital expenses

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Medicare (contd)

• Part B is voluntary, with a monthly premium, and
  covers doctors fees and other medical services
• Medigap insurance, sold by private companies,
  provides for gaps in Medicare coverage with Parts
  A and B

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Medicaid

• Provides health care for low income, blind, or
  aged persons.
• Payments may be used to offset the premiums,
  deductibles, and co-payments incurred with
  Medicare.

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Controlling Health Care Costs

• Live healthy
• Use a medical reimbursement or flexible spending
  account
• Consider COBRA when changing jobs
• Choose no health care coverage -- not recommended
  unless necessary

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Medical Reimbursement or Flexible Spending Account

• Optional employer-established savings plan funded
  with pre-tax dollars.
• Provides an account for paying unreimbursed
  medical expenses.
• Use it or lose it!
• Very flexible, but some expenses are not eligible
  for coverage.

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COBRA and Changing Jobs

• With a company of more than 20 employees,
  depending on why you leave the company, you can
  continue health coverage for 18 36 months.
• You pay the premium.
• Must notify the company within 60 days of leaving.

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Important Provisions in Health Insurance Policies

• Whos covered?
• Terms of payment
• Preexisting conditions
• Always maintain coverage to avoid exclusions
• Guaranteed renewability provision
• Exclusions
• Emotional and mental disorders

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Disability Insurance

• Provides income (67 to 80 of after-tax income)
  in the event of a long-term illness or injury
• Anyone who depends on earned income should have
  disability coverage

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Disability Insurance (contd)

• Sources of disability insurance
• Workers Compensation
• Social Security
• Purchase through your employers benefit plan
• Amount of coverage depends on the amount of
  income to be replaced

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Disability Insurance Features That Make Sense

• Determine the providers definition of disability
  -- make sure it is not too restrictive
• Residual or partial payments when returning to
  part-time work
• Duration of disability benefits
• short-term disability -- 6 months to 2 years
• long-term disability -- until age 65 to 70 or for
  the insureds lifetime

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Disability Insurance Features That Make Sense
(contd)

• Waiting (or elimination) period
• Waiver of premium provision
• Noncancelable provision
• Rehabilitation coverage provision

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Long-Term Care Insurance

• Provides a daily dollar benefit for the costs of
  long-term care
• Expensive, with many exceptions and conditions
  for coverage (e.g. ADLs)
• Who needs it?
• Those with savings to protect.
• Those with a family history of long-term
  disabilities.

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Important Long-Term Care Insurance Provisions

• Provisions which control qualification for
  benefits
• Type of care covered
• Benefit period
• Waiting period
• Inflation adjustment provision
• Waiver of premium provision
• Noncancelability provision