Chapter 13- Buying Life Insurance

13.1 Explain the defects in the traditional net cost method for determining the cost of life insurance.
13.2 Explain the interest-adjusted surrender cost index and net payment cost index for determining the cost of life insurance.
13.3 Explain the yearly rate-of-return method for determining the annual rate of return on the saving component in a life insurance policy.
13.4 Explain how federal income taxes apply to life insurance and how federal estate taxes are calculated on an estate.
13.5 Describe the seven rules to follow when purchasing life insurance.
13.6 Understand how life insurance premiums are calculated.

The cost of a life insurance policy is defined as the difference between the premiums paid and the benefits received upon policy surrender or upon the death of the insured.
Four major factors must be considered when determining the cost:
1. Annual premiums
  d 2. Cash values
2. Dividends
3. Time value of money

The traditional net cost method calculates annual net cost as follows:
- Cash values and expected dividends are deducted from the annual premiums, resulting in a net cost per year figure.
- Deficiency: This method fails to take into account the time value of money, which is a crucial financial concept.

Exhibit 13.1: Traditional Net Cost Method
- Total premiums for 20 years: $2,642
- Subtract accumulated dividends for 20 years: $599
- Net premiums for 20 years: $2,043
- Subtract the cash value at the end of 20 years: $2,294
- Insurance cost for 20 years: -$251
- Net cost per year:
- $ext{Net Cost per Year} = - rac{251}{20} = -12.55$
- Cost per $1,000 per year:
- ext{Cost per $1,000/year} = -12.55 imes rac{1}{10} = -1.26

Interest-adjusted cost method: A more accurate method as it factors in the time value of money.
- Surrender Cost Index:
- Evaluates the cost of life insurance if the policy is surrendered at the end of a specified time period (e.g., 10 or 20 years), considering compound interest.
- Net Payment Cost Index:
- Assesses the comparative cost of a policy assuming death occurs at the end of a specified time period, assuming the policy is not surrendered.

Exhibit 13.2: Surrender Cost Index
- Total premiums for 20 years, adjusted for interest (5%): $4,586
- Subtract dividends for 20 years (also adjusted): $824
- Net premiums for 20 years (interest adjusted): $3,762
- Cash value at the end of 20 years: $2,294
- Amount that $1 deposited annually will accumulate to in 20 years at 5%: $34.719
- Insurance cost for 20 years (interest adjusted): $1,468
- Interest-adjusted cost per year:
- $ext{Cost per Year} = rac{1,468}{34.719} = 42.28$
- Cost per $1,000 per year:
- ext{Cost per $1,000/year} = 42.28 + 10 = 4.23

Exhibit 13.3: Net Payment Cost Index
- Total premiums for 20 years accumulated at 5%: $4,586
- Dividends subtracted: $824
- Insurance cost for 20 years: $3,762
- Amount that $1 will accumulate to in 20 years at 5%: $34.719
- Interest-adjusted cost per year:
- $ext{Cost per Year} = rac{3,762 + 34.719}{10} = 108.36$
- Cost per $1,000 per year:
- ext{Cost per $1,000/year} = rac{108.36}{10} = 10.84

Interest-adjusted cost indices are crucial for comparing policies across different insurers.
Variations in cost indices can be significant among insurers, demonstrating the importance of comparing different options.
Most consumers rely on premiums for comparison, but cost indices offered by agents provide more comprehensive insights.

This Act mandates that insurers must present specific information to applicants:
- Narrative Summary: Describes the basic characteristics of the policy.
- Numeric Summary: Shows premium outlay, accumulation account value, cash surrender values, and death benefits.
- It also prohibits certain deceptive sales practices and requires annual reporting by insurers.

The annual rate of return on the savings component of a life insurance policy is a crucial consideration for long-term investments.

Linton yield: The average annual rate of return on a cash-value policy if held for a specified number of years.
Limitation: Current information is not easily accessible to consumers, reducing its usefulness.

Based on the formula:
$ext{Yearly Rate of Return} = rac{(Amount available at end of year + Assumed price of protection component) - Amount available at beginning of year}{1}$
The information for this calculation is readily available to consumers.

Lump Sum Payments: Life insurance proceeds paid as a lump sum to a beneficiary are generally income-tax free.
Periodic Payments: The interest component is taxed as ordinary income.
Premiums: They are typically not deductible.
Dividends: Not taxable; however, retained dividends generating interest are taxable.
Cash Value Surrender: Any gain realized when surrendering a policy is taxed as ordinary income.

Life insurance benefits are included in the gross estate for federal estate tax purposes if:
- The insured had ownership interest in the policy, or
- The proceeds are payable to the insured's estate.
Proceeds may be excluded from the gross estate if transferred to another individual through an absolute assignment more than three years before death.

A federal estate tax becomes payable if the decedent's estate exceeds specific limits.
The tentative tax on the taxable estate can be reduced or eliminated using a unified credit. Components of the gross estate include:
- Property owned by the deceased.
- Half of the value of jointly owned property with a spouse.
- Life insurance proceeds where there is ownership interest in the policy.
Allowable deductions may include marital deductions and others to reduce the taxable estate.