Learning Objectives part 1 of 2

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Chapter 11
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Learning Objectives (part 1 of 3)

• Describe when a person should and should not have
  life insurance
• Describe the basic differences between a term and
  a cash value policy
• Describe the various types of cash value policies
• Discuss the appropriateness of borrowing against
  a whole life policy

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Learning Objectives (part 2 of 3)

• Describe participating policies, riders, and
  viatical settlements
• Compute the value associated with buying term and
  investing the difference
• Compute how much life insurance a person should
  have
• Discuss whether a survivor should pay off a
  mortgage

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Learning Objectives (part 3 of 3)

• Describe the way a life insurance company rates a
  person
• Describe how insurance agents are compensated and
  how this might influence their recommendations
• Discuss when insurance coverage should be
  reviewed

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Who Should Buy Life Insurance

• Anyone and everyone who has dependents counting
  on financial support from the income that the
  insured would earn.
• Dependents might include
• Minor children
• Non working spouse
• Parents who are being supported

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Who Should NOT Buy Life Insurance

• People with no dependents
• Examples might include
• DINKs where each could live on their own income
• Children
• Retirees
• Non working spouses

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Policy Owner vs. Insured

• Policy Owner
• Pays the premium
• Controls the policy (e.g., can change the
  beneficiary, cash it in)
• Insured
• Person whose life is covered
• If not same as policy owner, must give permission
  to policy owner for the policy

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Term Insurance (1 of 2)

• Good for a fixed time period only
• Similar to auto insurance (if have no claim, then
  at end of term have nothing more than cancelled
  checks)
• Always the cheapest premium per 1,000 of coverage

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Term Insurance (2 of 2)

• Large variety of term policies
• 1-year, 5-year, 10- year, 20-year
• To age 65, to age 90
• Decreasing Term (Mortgage insurance)

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Cash Value Policy (1 of 2)

• May be for the life of the insured
• A cash value associated with the policy, so that
  if policy cancelled, the cash value belongs to
  the policy owner
• Can usually borrow against the cash value

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Cash Value Policy (2 of 2)

• Large variety of cash value policies
• Whole life
• Modified Premium or Graded
• Limited Pay
• Single Premium
• Endowment
• Variable Life
• Universal Life
• Variable Universal Life

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Borrowing Against a Cash Value Policy (1 of 2)

• Policy usually has a stated rate for policy loans
  
• Maximum loan usually up to 95 of current cash
  value
• No fixed repayment schedule
• Deduct from death benefit if insured dies with
  loan outstanding

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Borrowing Against a Cash Value Policy (2 of 2)

• Drawbacks to policy loan
• Reduction in death benefit
• Advantages of policy loan
• Potential investment arbitrage
• Give money to beneficiary now
• Death benefit need may be lower
• Enjoy some of money while insured still alive

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Participating Policies

• Company pays a dividend to the policy owner
• Dividends are tax free as considered rebate of
  premium
• Dividends make projecting the true cost of a
  policy a best guess effort

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Riders

• An attachment to a standard policy
• Could be free or might require an extra premium
• Common riders include
• Conversion Feature
• Double Indemnity
• Disability Waiver
• Accelerated Death Benefits

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Viatical Settlements

• Policy owner sells an existing policy to a third
  party
• Similar to an accelerated death benefit
• Usually substantial discounts to face value (even
  if insured terminally ill)
• May be only way to raise cash while insured still
  alive

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Buying Term Investing the Difference (1 of 3)

• True implementation requires
• Buy same death benefit as with W.L.
• Note the difference in premiums
• Each year, invest the difference in premiums
• Use the value of the investment to reduce the
  death benefit when the term policy comes up for
  renewal

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Buying Term Investing the Difference (2 of 3)

• Pros of this strategy
• With reasonable rates of return, will have a
  larger estate at time of death if make all
  investments on schedule
• Even if dont follow this strategy, then enjoy
  spending the premium difference while still alive

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Buying Term Investing the Difference (3 of 3)

• Cons of this strategy
• If fail to save premiums, then term premiums
  become prohibitive later in life
• May not be able to renew term
• Most people dont actually save premium
  differences

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How much life insurance should a person have?

• appropriate size premium approach
• human life value approach
• multiple of earnings approach
• needs approach

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Appropriate Size Premium

• Determine the maximum premium a policy owner is
  willing to pay
• Buy as much insurance as this premium will allow
• Rules of thumb are 5 to 10 percent of family
  budget

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Human Life Value

• Starts with estimates of future wage income of
  the insured
• Reduces this by portion spent on the insured
• Remainder is discounted
• The sum of present value is the human life value

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Multiple of Earnings

• Assumes that the ratio of human life value to
  current wage rate is approximately the same for
  people with similar incomes and ages
• Thus, one determines these ratios and constructs
  a look-up table for the various combinations of
  age and income

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Needs (1 of 3)

• Most complex of the four approaches
• Based on what expenses the survivors would face
  if the insured were to die
• Easy to be emotional in deciding what one wants
  their survivors to have if they die, thus could
  lead to an overstatement of insurance needs

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Needs (2 of 3)

• Four parts to calculation
• Immediate cash needs at time of death
• Financial and legal expenses
• Outstanding bills
• Final expenses
• Project annual income for survivors and subtract
  estimated annual expenses

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Needs (3 of 3)

• Take the present value of the differences
• Sum the present values and subtract current
  insurance coverage and other financial resources
  that are available

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Which is the best approach?

• Appropriate size premium not relevant
• Human life value Maximum coverage
• Multiple of Earnings usable if cant use a
  better approach
• Needs Maximum coverage
• Suggested approach Lesser of HLV Needs (one
  should never be worth more dead than alive)

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Should a survivor pay off a mortgage?

• Paying off a mortgage is equivalent to investing
  the money risk-free at the mortgage rate
• Not a good idea if it could be invested at a
  better (risk-adjusted) rate elsewhere
• Not a good idea if have liquidity problems

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Setting your premium

• Starts with life expectancy based on the
  actuarial table (same for all companies)
• Each insurer then applies own standards to
  determine the likelihood you will survive. These
  include
• Medical exam
• Smoking history
• Hobbies (e.g., skydiving)
• Profession (e.g., policeman)

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How insurance agents are compensated

• Most of compensation is a large percentage of the
  first years premium
• Remainder of compensation is a small percentage
  of each years premium thereafter
• Like to sell policies with large premiums, and
  like to upgrade policies

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When to review coverage

• A review is appropriate primarily when there is a
  major change in ones personal situation. These
  include
• Birth or death of a child (even better, when
  plans are made to have a child)
• A child leaving home
• Marriage, divorce, death of a spouse
• Significant change in income