Class 13 Insurance and Risk Management

1
Class 13Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Winter 2007

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Todays Agenda

• Review Types of Life Insurance
• Life Insurance Contractual Provisions
• Dividend Options
• Non-forfeiture Options
• Settlement Options
• Use of a Trust
• Additional Life Insurance Benefits

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Ordinary Life Insurance

• Lifetime protection to age 100
• Policy endows at age 100, if Insured still alive
• Level premiums
• Overcharge for protection in early years
• Undercharge in later years
• Investment or savings element
• No separate account
• Specified in policy
• Guaranteed

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Tax Treatment Ordinary Life Insurance

• Death benefits are not taxed (if paid to a named
  beneficiary, not estate)
• Income tax not paid on increases in cash value
  while the policy is in force
• Upon surrender, income tax is paid on
• Cash surrender value - sum of all premiums
• sum of all policyholder dividends

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Endowment Insurance

• Pays face amount
• To the beneficiary, if the insured dies within a
  specified period
• To the insured, if the Insured survives to the
  end of the specified (endowment) period
• Level premium payment
• Favorable tax treatment has been lost

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Limited Payment Life

• Permanent insurance protection to age 100, like
  ordinary life
• Premium are paid for only a limited period
• Level premium payment

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Universal Life Vs. Ordinary Life

• Unbundling Separate charges for
• Protection
• Savings
• Expenses charged for separately
• Flexible premium payments
• Cash value does not follow a fixed schedule
• Cash withdrawals permitted

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Universal Life Cash Value

• Cash value varies with
• Policyholders premium payments
• Insurers expense and mortality charges
• Rate of interest credited

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UL Interest Rate Credited

• The higher of
• Minimum rate (usually guaranteed)
• Current interest rate (not guaranteed)
• Current interest rate changes periodically
• Depends on market conditions
• Often linked to short term interest rates

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Universal Life Tax Treatment

• Favorable income-tax treatment preserved
• Death benefit paid to named beneficiary normally
  income-tax free
• Interest credited to cash value is tax deferred

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EXHIBIT 17.2 Universal Life Insurance Death
Benefits
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Variable Life

• Similar to whole life
• Main differences
• Cash value does not follow a fixed schedule it
  varies with
• return earned on portfolio of mutual funds chosen
  by policyholder
• Death benefit
• minimum is guaranteed,
• varies with cash value

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EXHIBIT 17.4 Comparison of Major Life Insurance
Contracts
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EXHIBIT 16.3 Relationship Between the Net Amount
at Risk and Legal Reserve
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Overview Life Insurance Contractual Provisions

• Ownership Clause
• Entire Contract Clause
• Incontestable Clause
• Suicide Clause
• Grace Period
• Reinstatement Clause

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Overview Life Insurance Contractual Provisions
(cont.)

• Misstatement of Age Clause
• Beneficiary Designation
• Change of Plan Provision
• Exclusions and Restrictions
• Assignment Clause
• Policy Loan Provision
• Automatic Premium Loan

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Ownership Clause

• Possible owners
• Insured
• Beneficiary
• Third party

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Owners Rights

• Change the beneficiary (unless irrevocable)
• Surrender the policy
• Receive dividends
• Elect settlement options

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Ownership Change

• File appropriate form with company
• Policy may need to be endorsed
• Key point
• Generally, owner free to exercise rights
• Without beneficiarys consent

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Entire Contract Clause

• Life insurance contract and attached application
• Constitute the entire contract between the
  parties

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Entire Contract Clause (cont.)

• Statements made on application are
• Representations
• Not warranties
• Claim cannot be denied unless
• Statement made is a material representation and,
• Statement is part of the application

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Two-fold Purpose Entire Contract Clause

• Prevents the Insurer from amending policy without
  consent of owner
• Protects the beneficiary

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Incontestable Clause

• Insurer has 2 years to contest the policy on the
  basis of
• Material misrepresentation
• Concealment
• Fraud

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Incontestable Clause

• Exception Limited set of outrageous fraud
  situations clearly violating public interest
• Purchase with intent to murder insured
• A person other than applicant takes medical exam
• Insurable interest does not exist at policy
  inception

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Suicide Clause

• If insured commits suicide within two years of
  policy issuance date,
• Face amount will not be paid
• Instead, refund of premium will be made
• Purpose Reduce adverse selection

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Suicide Clause Legal Framework

• Legal presumption against finding of suicide
• Death normally considered an unintentional act
• Insurer has burden of proof to prove insured
  committed suicide

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Grace Period

• 31-day period in which overdue premium can be
  paid without lapse of policy.
• Insurance is in-force during grace period
• Universal life and other flexible premium
  policies provide
• Longer grace periods
• E. g., 61 days

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Reinstatement Clause

• Provision allowing policy owner to reinstate a
  lapsed policy
• Requirements
• Evidence of insurability
• Payment of past-due premiums
• Re-payment or reinstatement of policy loans
• Reinstatement must occur within a certain period,
  such as three years or five years
• Policy must not have been surrendered for its
  cash value.

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Reinstated Policy Vs. New Policy Advantages

• Lower premiums
• No additional acquisition expenses
• Higher cash values and dividends
• Suicide and incontestable clause may have expired
• Reinstated policy may contain more favorable
  policy conditions (e. g, lower interest rate on
  loans)

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Reinstated Policy Disadvantages

• Substantial cash outlay required if policy lapsed
  for several years
• New life products could have lower premiums
  because of
• Lower mortality rates
• Lower expense assumptions

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Misstatement of Age or Sex Clause

• Any amount payable under policy (Death benefit,
  cash value, etc.)
• Reflects the amount that premiums would have
  purchased if the correct age and sex had been
  used.

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Misstatement of Age Example

• Male age 35 applies for 20,000 of ordinary life
• Misstates age as 24.
• Actual premium rate charged, age 34, per 1000 of
  coverage 19.
• Premium rate that should have been charged, age
  35, per 1000 of coverage 20.
• If insured dies and misstatement of age is
  discovered, death benefit payment reduced as
  follows
• 19/20 x 20,000 19,000

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Beneficiary Designation

• Primary and contingent
• Revocable and irrevocable
• Specific and class

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Primary Vs. Contingent Beneficiary

• Primary First beneficiary entitled to receive
  policy proceeds upon insureds death
• Contingent Entitled to receive proceeds if
  primary beneficiary dies before the insured

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Key Issue Primary Vs. Contingent Beneficiary

• Many families name children as contingent
  beneficiaries
• Minor children lack legal capacity to receive
  policy proceeds directly

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Primary Vs. Contingent Issue (cont)

• Many insurers will require a guardian to be named
• If court appoints guardian, payment may be
  delayed and legal expenses incurred.

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Primary Vs. Contingent Issue (cont)

• Two possible solutions
• Name guardian in will who can legally receive
  death proceeds on childrens behalf.
• Pay policy proceeds to a trustee, who has
  discretion and authority to use funds for
  childrens welfare

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Revocable Vs. Irrevocable Beneficiary

• Revocable Policyowner reserves right to change
  beneficiary without beneficiarys consent
• Irrevocable Beneficiary cannot be changed
  without beneficiarys consent
• Most policies provide that if irrevocable
  beneficiary dies before insured,
• All rights to policy revert to owner, who then
  can name a new beneficiary

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Specific Vs. Class Beneficiary

• Specific Beneficiary specifically named and
  identified
• Class Member of a class is designated as
  beneficiary.
• Most Insurers restrict class designations because
  of
• Problems with identifying members of the class
• Class designation requires great care

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Example My Children Vs. Children of Insured

• My children means all children of insured share
  equally in policy proceeds, including
• Legitimate
• Illegitimate
• Adopted
• Children of Insured
• Includes insureds children by any marriage
• Excludes spouses children by a former marriage

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Change of Plan Provision

• Purpose Provide flexibility to policyowner to
  respond to changing needs for insurance
• Allows exchange of present policy for different
  contract

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Change of Plan Provision Rules

• Change to higher-premium policy
• Policyowner pays difference in policy reserve of
  new policy versus original contract
• No evidence of insurability required

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Change of Plan Provision Rules

• Change to lower-premium policy
• Insurer refunds difference in cash values
• Evidence of insurability is required
• Reduced cash value increases insurers net amount
  at risk
• Lower premium policy provides higher pure
  insurance protection

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Exclusions and Restrictions

• Suicide clause
• First two years only (most contracts)
• One year (Appendix c, p702)
• War clause
• Excludes payment if insured dies as a direct
  result of war
• Purpose To reduce adverse selection
• Not contained in all policies

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Exclusions and Restrictions (cont.)

• Aviation exclusion variations
• Exclude aviation deaths other than as fare-paying
  passenger on regularly schedule airline
• Exclude military aviation or cover at additional
  premium only
• Exclude private pilot not meeting certain flight
  standards, or charge higher premium

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Exclusions and Restrictions (cont.)

• Hazardous activities may be discovered in initial
  underwriting
• Auto racing
• Scuba diving
• Hang-gliding
• Travel or residence in a dangerous country
• Underwriter may exclude or cover only with
  payment of extra premium

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Payment of Premium

• Payment modes Annual, semi-annual, quarterly or
  monthly
• Carrying charge is relatively expensive
• Example p.399
• Annual premium 1,000
• Semiannual premium 520
• Apparent charge 4 40/1000
• Effective carrying charge
• 16.7 40/(1000-520) x 2

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Assignment Clause

• Life Insurance policy is freely assignable
• Two types of assignment
• Absolute assignment
• Collateral assignment

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Absolute Assignment

• All ownership rights are transferred to a new
  owner
• Church
• Charity
• Educational Institution
• Insured
• Beneficiary
• New owner receives all ownership rights in the
  policy

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Collateral Assignment

• Policyowner assigns policy as collateral for a
  loan
• Assignment form typically used
• American Bankers Association assignment form
• Collateral assignment confers limited rights in
  the policy
• Assignee entitled to receive death proceeds only
  to extent of loan
• Balance of proceeds are paid to beneficiary

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Purpose/Workings Assignment Clause

• Purpose To protect insurer from paying policy
  proceeds twice
• If Insurer is not notified of assignment,
• Proceeds are paid to named beneficiary
• Insurer is relieved of any further obligation
• Even if a valid assignment is in existence

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Purpose/Workings Assignment Clause

• If Insurer is notified of assignment,
• A new contract exists between insurer and
  assignee
• Insurer recognizes assignees rights as superior
  to beneficiarys rights
• Implications?

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Policy Loan Provision

• Allows policyowner to borrow the cash value
• Advantages
• Low annual percentage rate
• No paperwork, no credit check
• Flexibility in repaying, no fixed repayment
  schedule
• Disadvantages
• Heavy borrowing may cause policy to lapse
• Amount of protection is reduced

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Automatic Premium Loan

• Allows overdue premiums to be paid by borrowing
  from the cash value at the end of the grace
  period.
• Purposeto prevent the policy from lapsing
• Main disadvantages
• If overused, cash values may become exhausted,
  leading to policy lapse
• Amount of protection is reduced

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Participating Policies

• Participating policy definition
• Policy which pays dividends
• Participating policy
• Gives policyowner right to share in the divisible
  surplus of insurer
• Can be issued by both a stock insurer and a
  mutual insurer

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Sources of Surplus for Dividends

• Higher interest earnings than assumed
• Lower mortality than expected
• Lower operating expenses than expected
• Relationship to design of Universal Life?

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Dividend Options

• Cash
• Reduction of premiums
• Accumulate at interest
• Paid-up additions
• Term insurance

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Dividend Options (cont.)

• Cash
• Dividend payable after policy in force for a
  stated period
• Policyowner receives a check usually on
  anniversary date
• Reduction of premiums
• Dividend used to reduce the next premium coming
  due.

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Dividend Options (cont.)

• Accumulate at interest
• Company guarantees minimum rate on dividend
  accumulations
• But, may pay a higher rate depending on market
  conditions.
• Paid-up additions
• Dividend used as a single premium to buy
  additional amounts of paid-up insurance.

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Dividend Options (cont.)

• Term insurance (Fifth Dividend)
• Dividend used to purchase term insurance.
• Two options
• One-year term
• Yearly renewal term (limited availability)

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Other Dividend Uses

• Convert policy to a paid-up contract
• Policy becomes paid-up
• when reserve value of basic contract
• plus reserve value of paid up additions
• equals reserve value of net single premium
  paid-up policy
• at insureds attained age

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Other Divided Uses (cont.)

• Mature policy as an endowment
• Policy will mature
• When the reserve of basic contract
• Plus reserve of paid-up additions
• Equal the face amount of the policy

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Non-forfeiture Options

• Cash Value
• Reduced Paid-up Insurance
• Extended Term Insurance

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Non-forfeiture Option

• Surrender of policy for its cash value
• Little or no cash value during early years
• Payment of cash value can be delayed for six
  months if policy is surrendered (seldom used).

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Reduced Paid-Up Insurance

• Cash value used to buy a reduced paid-up policy
• Appropriate option when person has limited
  income, but still has some life insurance needs

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Extended Term Insurance

• Cash value used to extend full face amount of
  insurance
• into the future as term insurance
• for a certain number of years and days.

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Settlement Options

• Cashmost proceeds are paid as cash
• Interest Option
• Fixed Period Option
• Fixed Amount Option
• Life Income Options

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Settlement Options Advantages

• Periodic income to the family
• Guaranteed principal and interest
• Can be useful in life insurance planning
• Long-term guarantees
• No additional cost

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Settlement Option Disadvantages

• Higher yields elsewhere
• Settlement agreement may be inflexible and
  restrictive.
• Life income options not attractive at younger
  ages
• Insurance windfall can create problems for the
  beneficiary.

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Interest Settlement Option

• Interest paid to the beneficiary
• Minimum interest rate guaranteed
• Beneficiary can make withdrawals
• Advantages
• flexibility, may allow change to another option
• Main disadvantage higher returns elsewhere.

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Fixed Period Settlement Option

• Pays monthly, quarterly, semiannual, or annual
  payments
• Death of beneficiary
• Remaining payments go to a contingent beneficiary
  
• To the estate of primary beneficiary if the
  contingent beneficiary dies
• Useswhen income needed for definite period of
  time
• Social Security black-out period
• readjustment period
• family dependency period
• Limitationsinflexible partial withdrawals not
  allowed

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Fixed Amount Settlement Option

• Specified amount paid to beneficiary each time
  period
• Advantages
• Considerable flexibility on withdrawals
• May allow change to another option or
• Increase and decrease in fixed amount

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Life Income Settlement Options

• Life income only
• Life income with a period certain
• Life income with refund option
• Joint-and-survivor life income option

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Use of a Trust

• Alternative to Settlement Option
• Desirable when
• Amount of insurance is substantial
• Judgment in amount and timing of pay-outs is
  required
• Example situations
• Minor children
• Mentally handicapped adult
• Disadvantages
• Must pay trustees fee
• Returns not guaranteed

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Nonforfeiture Options (Dollar Amount for Each
100 of Ordinary Life Insurance Issued at Age 21)
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Fixed Period Option (Minimum Monthly Income
Payments per 1000 Proceeds, 3 Interest)
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EXHIBIT 18.1 Nonforfeiture Options (Dollar
Amount for Each 1000 of Ordinary Life Insurance
Issued at Age 21)
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EXHIBIT 18.2 Fixed-Period Option (Minimum
Monthly Income Payments per 1000 Proceeds, 3
Percent Interest)
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EXHIBIT 18.3 Life Income Options (Minimum
Monthly Income Payments per 1000 Proceeds)
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EXHIBIT 18.4 Joint-and-Survivor Life Income
Option (Minimum Monthly Income Payments per 1000
Proceeds)
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Additional Life Insurance Benefits

• Waiver-of-Premium
• Guaranteed Purchase Option
• Double Indemnity Rider
• Cost-of-Living Rider
• Accelerated Death Benefits Rider

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EXHIBIT 17.1 Illustrative Examples of Term Life
Insurance Premiums, 250,000
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EXHIBIT 17.3 100,000 Universal Life Policy,
Level Death Benefit, Male Age 25, Nonsmoker, 5.5
Percent Assumed Interest
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EXHIBIT 17.3 (continued) 100,000 Universal Life
Policy, Level Death Benefit, Male Age 25,
Nonsmoker, 5.5 Percent Assumed Interest
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EXHIBIT 17.4 Comparison of Major Life Insurance
Contracts
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State Laws Require Rates To Be

• Adequate
• Not excessive
• Not unfairly discriminatory

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Business Rate-Making Objectives

• Simplicity
• Stability
• Responsiveness
• Encourage loss prevention

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EXHIBIT 27.1 Commissioners 1980 Standard
Ordinary Mortality Table, Male Lives
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EXHIBIT 27.1 (continued) Commissioners 1980
Standard Ordinary Mortality Table, Male Lives
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EXHIBIT 27.2 Present Value of 1 at 5 Percent
Compound Interest
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EXHIBIT 27.3 Figuring the NSP for a Five-Year
Term Insurance Policy