insurance quiz 3

premature death

defined as (1) the death of a family head with outstanding unfulfilled financial obligations, or (2) the death of a person that creates negative business consequences.

costs of premature death

• First, the family’s share of the deceased breadwinner’s future earnings is lost forever.

• Second, death results in additional expenses such as funeral costs, uninsured medical bills, higher childcare expenses, estate settlement costs, and other final expenses.

• Third, because of insufficient income, some families will experience a substantial reduction in their standard of living.

• Finally, survivors face certain noneconomic costs such as intense grief, loss of a parental role model, and counselling and guidance for the children.

economic justification for life insurance

The purchase of life insurance is economically justified if the insured has earned income, and others are dependent on those earnings for part or all of their financial support.

family types

• single people

  • low need

• single parent

  • high need

• two income earners with children

  • high need

  • low need if no children

• traditional families

  • both parents need life insurance

• blended families

  • both need

• sandwiched families

  • high need

the 2 approaches of how much life insurance to own

• human life value approach

• needs approach

human life value

defined as the present value of the family’s share of the deceased breadwinner’s future earnings.

how to calculate human life value

1. Estimate the individual’s average annual earnings over his or her productive lifetime.

2. Deduct federal and state income taxes, Social Security taxes, life and health insurance premiums, and the costs of self-maintenance. The remaining amount is used to support the family.

3. Determine the number of years from the person’s present age to the contemplated age of retirement.

4. Using a reasonable discount rate, determine the present value of the family’s share of earnings for the period determined in Step 3.

limitations of human life value approach

• First, it ignores other sources of income, such as Social Security survivor benefits, as well as the income from individual retirement accounts (IRAs), 401(k) plans, and private pension death benefits.

• Second, the basic model does not consider occupational differences; work earnings and expenses are assumed to be constant; and employee benefits are ignored.

• Third, the amount of money allocated to the family can quickly change because of divorce, birth of a child, or death of a family member.

• In addition, the long-run discount rate is critical; the human life value can be substantially increased by assuming a lower rate.

• Finally, the effects of inflation on earnings and expenses are ignored.

needs approach

Method for estimating amount of life insurance appropriate for a family by analyzing various family needs that must be met if the family head should die and converting them into specific amounts of life insurance. Financial assets are considered in determining the amount of life insurance needed.

most important needs for families

• Estate clearance fund

• Income during the readjustment period

• Income during the dependency period, until the youngest child reaches 18

• Life income to the surviving spouse, including income during and after the blackout period

• Special needs

  • Mortgage redemption fund

  • Educational fund

  • Emergency fund

  • Mentally, emotionally, or physically challenged family members

• Retirement needs

estate clearance fund (needs)

which provides the cash needed immediately for burial expenses; uninsured medical bills; installment debts; estate administration expenses; and estate, inheritance, and income taxes.

income during the readjustment period (needs)

a one- or two-year period following the breadwinner’s death. During this period, the family should receive approximately the same amount of income received while the family head was alive. The purpose of the readjustment period is to give the family time to adjust its standard of living.

dependency period (needs)

follows the readjustment period; it is the period until the youngest child reaches age 18. The family should receive income during this period so that the surviving spouse can remain at home, if necessary, to care for the children. The income needed during the dependency period is substantially reduced if the surviving spouse is already in the labor force and plans to continue working.

life income to surviving spouse (needs)

Another important need is to provide life income to the surviving spouse, especially if he or she is older and has been out of the labor force for many years. Two income periods must be considered: (1) income during the blackout period and (2) income to supplement Social Security benefits after the blackout period.

blackout period

refers to the period from the time that Social Security survivor benefits terminate to the time the benefits are resumed. Social Security benefits to a surviving spouse terminate when the youngest child reaches age 16 (or who is disabled before age 22) and start again when the spouse attains age 60.

mortgage redemption fund (special needs)

The amount of monthly income needed by surviving family members is greatly reduced when monthly mortgage payments or rent payments are not required.

educational fund (special needs)

The family head may want to provide an educational fund for the children. If the children plan to attend a private college or university, the cost will be considerably higher than at a public institution.

emergency fund (special needs)

A family should also have an emergency fund. An unexpected event may occur that requires large amounts of cash, such as major dental work, home repairs, or a new car.

Mentally, emotionally, or physically challenged family members (special needs)

Additional funds may be needed for educating, training, and caring for children or adult family members who are mentally, emotionally, or physically challenged.

retirement needs

Because the family head may survive until retirement, the need for adequate retirement income should also be considered. Most retired workers are eligible for Social Security retirement benefits and may also be eligible for retirement benefits from their employer.

• If retirement income from these sources is inadequate, you can obtain additional income from cash-value life insurance, individual investments, a retirement annuity, an individual retirement account (IRA), or an employer-based retirement plan. Each of these options is described in later chapters.

the three reasons as to why people are uninsured according to the LIMRA

• Although term insurance premiums have declined to historically low levels, consumers believe life insurance is too expensive to purchase.

• Consumers have difficulty in making correct decisions about the purchase of life insurance.

• Many consumers simply procrastinate and never get around to buying life insurance.

opportunity cost

refers to what the insured policyholder gives up when life insurance is purchased.

• The purchase of life insurance reduces the amount of discretionary income available for other needs

• Many families are in debt and have little savings

• After payment of high priority expenses, such as a mortgage, food and utilities, many families have only a limited amount of income to purchase life insurance

the two main types of life insurance

• term insurance

• cash-value life insurance

term insurance

Type of life insurance that provides temporary protection for a specified number of years with no savings element. It is usually renewable and convertible.

• Term insurance has several basic characteristics. First, the period of protection is temporary, such as 1, 5, 10, 20, or 30 years. Unless the policy is renewed, the protection expires at the end of the period.

• Most term insurance policies are renewable, which means the policy can be renewed for additional periods without evidence of insurability.

  • Premiums increase at each renewal

  • To minimize adverse selection, many insurers have an age limitation beyond which renewal is not allowed

• Most term insurance policies are also convertible, which means the term policy can be exchanged for a cash-value policy without evidence of insurability.

  • two methods: attained age, original age

• Finally, term insurance policies have no cash-value or savings element.

attained age method (term insurance converting)

the premium charged is based on the insured’s attained age at the time of conversion and the policy is like a newly issued cash value policy in every respect.

original age method (term insurance converting)

the premium charged is based on the insured’s original age when the term insurance was first purchased. Most insurers offering the original-age method require the conversion to take place within a certain time period, such as five years, from the issue date of the term policy. A financial adjustment is also required.

types of term insurance

• Yearly renewable term

• 5-, 10-, 15-, 20-, 25-, or 30-year term

• Term to age 65

• Decreasing term

• Reentry term

• Return of premium term insurance

Yearly renewable term insurance

is issued for a one-year period, and the policyholder can renew for successive one-year periods to some stated age without evidence of insurability.

5-, 10-, 15-, 20-, 25-, or 30-year term

The premiums paid during the term period are level, but they increase when the policy is renewed.

A term to age 65 policy

provides protection to age 65, at which time the policy expires. The policy can be converted to a permanent plan of insurance, but the decision to convert must be exercised before age 65.

Decreasing term insurance

a form of term insurance where the face amount gradually declines each year. However, the premium is level throughout the period. In some policies, the premiums are structured so that the policy is fully paid for a few years before the coverage expires.

reentry term

a term insurance policy in which renewal premiums are based on select (lower) mortality rates if the insured can periodically demonstrate acceptable evidence of insurability. (i.e. good health)

Return of premium term insurance

a product that returns the premiums at the end of the term period, provided the insurance is still in force. Typical periods are 15, 20, 25, or 30 years.

appropriate uses of term insurance

• First, if the amount of income that can be spent on life insurance is limited, term insurance can be effectively used.

• Second, term insurance is appropriate if the need for protection is temporary.

• Finally, term insurance can be used to guarantee future insurability.

limitations of term insurance

• First, term insurance premiums increase with age at an increasing rate and eventually reach prohibitive levels.

• Second, term insurance is inappropriate if you want to save money for a specific need.

whole life insurance

a generic name for a cash-value policy that provides lifetime protection with level premiums.

• Whole life insurance is called ordinary life insurance if premiums are payable throughout the lifetime of the insured and limited payment life insurance if the premium period is less than the insured’s lifetime.

• A stated amount is paid to a designated beneficiary when the insured dies, regardless of when the death occurs.

types of whole life insurance

• ordinary life

• limited payment life

• endownmnet insurance

• variable life

• universal life

• variable universal life

• current assumption whole life

• indeterminate premium whole life

ordinary life insurance (whole)

a level-premium policy that accumulates cash values and provides lifetime protection to age 121. Age 121 is the end date of the mortality table, and premiums are paid throughout the insured’s lifetime.

• premiums are level throughout the premium-paying period.

• The excess premiums paid during the early years are accumulated at compound interest and are then used to supplement the inadequate premiums paid during the later years of the policy.

• Because state law regulates the method of investing and accumulating the fund, it is referred to as a legal reserve

  • Technically, the legal reserve is a liability item on the insurer’s balance sheet that must be offset by sufficient financial assets.

• The net amount at risk is the difference between the face amount of insurance and the legal reserve.

• A second characteristic is the accumulation of cash-surrender values, which is the amount paid to a policyholder who surrenders the policy.

  • As noted earlier, under a system of level premiums, the policyholder overpays for the insurance protection during the early years, which results in a legal reserve and the accumulation of cash values.

  • The policyholder has the right to borrow the cash value or exercise one of the cash-surrender options

  • Cash values should not be confused with the legal reserve. They are not the same thing and are computed separately

uses of ordinary life insurance

• An ordinary life policy is appropriate when lifetime protection is needed. This means that the need for life insurance will continue beyond age 65 or 70.

• Ordinary life insurance can also be used to save money.

limitation of ordinary life insurance

The major limitation of ordinary life insurance is that some ­people are still substantially underinsured after the policy is purchased.

• Because of the savings feature, some people may purchase an ordinary life policy when term insurance would be a better choice since term insurance can provide the full amount of protection needed.

limited payment policy

another type of traditional whole life insurance. The insurance is permanent, and the insured has lifetime protection.

• The premiums are level, but they are paid only for a certain period.

• The most common limited-payment policies are for 10, 20, 25, or 30 years.

paid up policy

• A policy is paid up when no additional premium payments are required; it mature when the face amount is paid asa death claim or as an endowment

• A paid-up policy at age 65 or 70 is another form of limited-payment insurance.

single premium whole life insurance

• An extreme form of limited-payment life insurance

• provides lifetime protection with a single premium.

endowment insurance (whole life)

ays the face amount of ­insurance if the insured dies within a specified period; if the insured survives to the end of the endowment period, the face amount is paid to the beneficiary at that time.

• Endowment insurance accounts for less than 1 percent of the life insurance in force.

variable life insurance (whole)

can be defined as a fixed-­premium policy in which the death benefit and cash values vary according to the investment experience of a separate account, which is similar to a mutual fund maintained by the insurer.

• A variable life policy is a permanent whole life contract with a fixed premium.

• The entire reserve is held in a separate account and is invested in common stocks or other ­investments.

• There are no minimum guaranteed cash values.

universal life insurance (whole)

(also called flexible premium life insurance ) can be defined as a flexible premium policy that provides protection under a contract that separates the protection and ­saving components

• Except for the first premium, the policyholder determines the amount and frequency of payments.

• The premiums, less-explicit expense charges, are credited to a cash-value account (also called an accumulation fund) from which monthly mortality charges are deducted and to which monthly interest is credited.

• In addition, universal life policies typically have a monthly deduction for administrative expenses.

Universal life insurance has certain characteristics, which include the following:

• Unbundling of protection and saving component

• Two forms of universal life insurance

• Considerable flexibility

• Cash withdrawals permitted

• Favorable income-tax treatment

separation of component parts (universal life insurance)

A distinct characteristic of universal life insurance is the separation or unbundling of the protection component and the saving component.

• Most policies have a target premium, which is a suggested level premium that will keep the policy in force for a specified number of years. However, the policyholder is not obligated to pay the target premium.

• A monthly mortality charge is deducted from the cash-value account for the cost of the insurance protection.

• Insurers typically deduct 5 to 10 percent of each premium for expenses.

• Interest earnings credited to the cash-value account depend on the interest rate.

  • There are two interest rates. The guaranteed cash value is credited with a contractually guaranteed ­minimum interest rate, such as 3 percent.

  • The cash values, however, may be credited with a higher current rate, such as 4 percent.

the two forms of universal life insurance

• Option A pays a level death benefit unless the amount at risk becomes too small at which time the death benefit will increase.

  • As the cash value increases over time, the net amount at risk declines. However, the death benefit is designed to increase automatically if the cash value exceeds certain corridor limits established in the Internal Revenue Code to maintain an acceptable relationship between cash value and the net amount at risk.

• Option B provides for a fluctuating death benefit. The death benefit is equal to a constant net amount at risk plus the accumulated cash value.

  • As the cash value fluctuates over time, the death benefit will also fluctuate by an identical amount.

considerable flexibility (universal life insurance)

• The policyholder determines the frequency and amount of premium payments. Premiums can be discontinued if there is sufficient cash value to pay mortality costs and expenses.

• The face amount of insurance can be increased with evidence of insurability. However, the face amount of insurance can be reduced with no evidence of insurability.

• The policy can be changed from a level death benefit to a death benefit equal to a specified face amount plus the policy cash value (with evidence of insurability).

• The policyholder can add cash to the policy at any time, subject to maximum guideline limits that govern the relationship between the cash value and the death benefit (tax law limitations).

• Policy loans are permitted at competitive interest rates.

• If the policy permits, additional insureds can be added.

• Part or all of the cash value can be withdrawn. Interest is not charged, but under Option B the death benefit is reduced by the amount of the withdrawal. Most insurers charge a fee for each cash withdrawal, such as $25. As noted earlier, policy loans are also permitted.

• Universal life insurance enjoys the same favorable federal income-tax treatment as traditional cash-value policies. The death benefit paid to a named beneficiary is normally received income tax free. Interest credited to the cash-value account is not taxable to the policyholder in the year credited.

limitations of universal life insurance

• The advertised rates of return on universal life insurance are often misleading.

• As a result, the earlier cash-value and premium-payment projections based on higher interest rates are misleading and invalid. Actual cash values will be substantially less than the projected values based on higher interest rates when the policy was first sold.

• As stated earlier, insurers can increase the current mortality charge for the cost of insurance up to some maximum limit. Other expenses may be hidden in the mortality charge.

• Another limitation is that some policyholders do not have a firm commitment to pay premiums. As a result, the policy may lapse because of nonpayment of premiums

indexed universal life insurance

a variation of universal life insurance with certain key characteristics.

• First, there is a minimum interest rate guarantee, which is usually lower than the minimum interest rate guarantee on a regular universal life policy.

• Second, additional interest may be credited to the policy based on the investment gains of a specific stock market index, such as the (S&P) 500 Index.

• Third, there is a formula for determining the amount of enhanced (additional) interest credited to the policy; the formula usually places a cap on the maximum upper limit of additional interest credited to the policy; the formula may also place a limit on the participation rate that applies to the index.

• Fourth, often consumers misunderstand and or have unrealistic performance expectations for this type of policy.

• Finally, consumers find that policies regulated under federal securities laws, as well as state insurance regulation, provide more complete disclosure than policies not federally regulated.

variable universal life insurance

is an important variation of whole life insurance. These policies are often sold as investments or tax shelters. Variable universal life insurance is similar to a universal life policy with two major exceptions:

• The policyholder determines how the premiums are invested, which provides considerable investment flexibility.

• The policy does not guarantee a minimum interest rate or minimum cash value. One exception, however, is that the policy may have a fixed-income account, which may guarantee a minimum interest rate on the account value.

• Variable universal life insurance policies have relatively high expense charges, which reduce the investment returns and erode the favorable tax treatment under the policy.

  • charges include front-end load for sales commissions and expense

  • back-end surrender charges

  • State premium taxes and federal taxes

  • Investment management fees

  • Mortality and expense charges

• Variable universal life insurance is a risky type of life insurance to own. There is a substantial investment risk that falls entirely on the policyholder.

current assumption whole life insurance

is a nonparticipating whole life policy in which the premiums and/or policy values are based on the insurer’s current mortality, investment, and expense experience.

the two forms of current assumption whole life insurance

• Low-premium products, with a low initial premium and a redetermination provision that allows the insurer to recalculate the premium after the initial guaranteed period expires

• High-premium products, with a provision that allows the policyholder to discontinue paying premiums after a certain time period.

vanishing premium life

was sold in the past based on sales illustrations that indicated a policy would become paid up if non-guaranteed interest rate projections were achieved.

• Unfortunately, all too often, the projected interest rates were not achieved, and many unhappy consumers filed law suits against some life insurers. As a result, the National Association of Insurance Commissioners developed a model law stating in part that an insurer or its representatives shall not use “the term ‘vanish’ or ‘vanishing premium,’ or a similar term that implies the policy becomes paid up, to describe a plan for using non-guaranteed elements to pay a portion of future premiums.

types of life insurance to avoid

• flight insurance at airports

• credit life insurance

• accidental death and dismemberment insurance

• cash value policies on children

modified life insurance

a whole life policy in which premiums are lower for the first three to five years and higher thereafter.

• The major advantage of a modified life policy is that applicants for insurance can purchase permanent insurance immediately even though they cannot afford the higher premiums for a regular whole life policy. Modified life insurance is particularly attractive to persons who expect that their incomes will increase in the future and that higher premiums will not be financially burdensome.

preferred risks

Most life insurers sell policies at lower rates to individuals known as preferred risks, whose mortality experience is expected to be lower than average. The policy is carefully underwritten and is sold only to individuals whose health history, weight, occupation, and habits indicate more favorable mortality than the average.

• A discount for non-smokers is a current example of a preferred risk policy. Most insurers offer substantially lower rates to non-smokers in recognition of the more favorable mortality that can be expected of this group.

joint life insurance

(also called a first-to-die policy) is a policy written on the lives of two or more people and is payable at the time of the death of the first person to die.

second to die life insurance

(also called survivorship life) is a form of life insurance that insures two or more lives and pays the death benefit at the time of the death of the second or last insured.

• The insurance usually is whole life, but it can be term.

• Second-to-die life insurance is now widely used in estate planning.

saving bank life insurance (SBLI)

a type of life insurance that was sold originally by savings banks in Massachusetts, New York, and Connecticut. Today, SBLI products are now sold nationally in most states and in the District of Columbia to consumers over the phone or through online websites. The objective of SBLI is to provide low-cost life insurance to ­consumers by holding down operating costs and payment of high sales commissions.

home service life insurance

Today, industrial life insurance in its original form has largely disappeared and has been replaced by home service life insurance ( also called monthly debit ordinary ), in which home premium ­collections generally are not made. The policyholder remits the premiums directly to the agent or to the company. The amount of life insurance per policy generally ranges from $5,000 to $25,000. Home service life insurance is relatively unimportant and accounts for less than 1 percent of all life insurance in force.

industrial life insurance

was a class of life insurance that was issued in small amounts, such as $100 or $500; the insurance typically was sold to low-income families; premiums were payable weekly or monthly, such as 25 cents weekly or monthly; and an agent of the company collected the premiums at the insured’s home. More than 9 out of 10 policies were cash-value policies.

group life insurance

an important type of insurance that provides life insurance to members of a group in a single master contract between the insurer and employer, or other group sponsor. Physical ­examinations are not required, and certificates of insurance are issued as evidence of insurance.