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Life Insurance and Annuities Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment insurance Whole life insurance Universal insurance Variable insurance Terminology Death benefit = amount beneficiaries receive

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Life Insurance and Annuities

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Life Insurance and Annuities

  • Terminology

  • Types of life insurance products

  • Tax treatment of life insurance

  • Term insurance

  • Endowment insurance

  • Whole life insurance

  • Universal insurance

  • Variable insurance

Ins301 Chp15 –Part1


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Terminology

  • Death benefit = amount beneficiaries receive

  • Cash value = amount of savings accumulation

  • Death protection = amount of pure death protection

    = death benefit - cash value

  • Face amount = stated amount of coverage

    = death benefit (for term, whole life, & some universal life)

    = death benefit - cash value (for some universal life)

  • Cash surrender value = the amount of money that the policyholder can withdraw (=cash value - surrender penalty)

Ins301 Chp15 –Part1


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Life Insurance Products: General Introduction

  • Term insurance

    • pure life insurance

  • Cash value life insurance

    • pure life insurance + Savings accumulation

    • whole life

    • universal life

    • variable life

    • Variable universal life

Ins301 Chp15 –Part1


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Tax Treatment of Life Insurance

  • Death benefits are not taxed

  • Income tax is 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

Ins301 Chp15 –Part1


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Implications of Tax Treatment

  • Implicit returns on savings accumulation

    • Escape taxation if insured dies

    • Tax deferred if the policy is surrendered

    • Partially taxed if policy is surrendered

      • Amount which is taxed is less than implicit return b/c part of premiums is cost of death protection

Ins301 Chp15 –Part1


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Term Insurance

  • Typically provides pure death protection over a fixed term, usually one year or five years. There is no savings feature and therefore no cash surrender value.

  • Data

    • 1/4 of policies

    • almost half of death protection purchased

  • Guaranteed renewable

  • Premium increases over time. Why?

Ins301 Chp15 –Part1


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Life Insurance Pricing

  • Ignore expenses and risk load

    ==> focus on net premiums

  • Use mortality table

    • Probability of dying at age x conditional on living through age x-1

    • Example: Probability of male dying at age 40 = 0.00302

  • Assume

    • Premiums paid at beginning of year

    • Claims paid at end of year

Ins301 Chp15 –Part1


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Pricing 1-Year Term

  • Find fair premium for $100,000 1-year term for 40 year-old

    • Interest rate = 10%

    • Insurer’s cash flows:

      Beg. of YearEnd of Year

      $100,000 with prob 0.00302

      Loss

      $0 with prob. 0.99698

      Expected claim cost = ________

      Premium = Present value of expected claim cost

      = __________

Ins301 Chp15 –Part1


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Pricing 1-Year Term

  • Find fair premium for $100,000 1-year term for 41 year-old

    • Interest rate = 10%

    • Insurer’s cash flows:

      Beg. of YearEnd of Year

      -$100,000 with prob ____________

      Premium

      $0 with prob. ____________

      Expected claim cost = ___________

      Premium = Present value of expected claim cost

      = ____________

Ins301 Chp15 –Part1


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Pricing 1-Year Term

  • Premium increases as probability of dying increases

Ins301 Chp15 –Part1


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Pricing 2-Year Term

  • Find fair premium for $100,000 2-year term for 40 year-old

  • Insurer’s claim costs:

    Beg. of Year 1End of Year 1End of Year 2

    -$100,000 -$100,000

    with prob 0.00302with prob x

    $0$0

    with prob. 0.99698with prob 1-x

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Pricing 2-Year Term

  • What is x? – it isthe probability of a 40 year-old dying in his 42nd year?

  • Mortality table:

    NumberNumber

    Ageof Peopleof Deaths

    409377232832

    419348913076

    Probability of 40 year-old dying in 41st year =_____ = ______

    Probability of 40 year-old dying in 42nd year =_____ = ______

Ins301 Chp15 –Part1


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Pricing 2-Year Term

  • Single premium

  • Level Premium

Ins301 Chp15 –Part1


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Endowment Insurance

  • Pays face amount if the insured dies, or if the insured survives the policy period

  • It is similar to a saving account

  • The US no longer grants tax advantage to endowment policies unless they have a very long duration, such as whole life insurance.

Ins301 Chp15 –Part1


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Whole Life Insurance

  • Policy period ends when insured reaches 100

  • Equivalent to endowment policy to 100

  • Premiums

    • single premium

    • limited pay – a level premium paid for a 10-year or 20-year period

    • continuous premium – level premium continue until the policyholder dies, surrenders the policy, or reaches the age of 100 (whichever comes first)

Ins301 Chp15 –Part1


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Whole Life Insurance

  • Premiums generally do not increase over time

    • But probability of dying increases over time

      ==> higher upfront premiums than with term

    • Policyholder “prepays” part of the cost of future death protection

      • entitled to prepayments if policy is surrendered

      • this is the cash value (savings accumulation)

Ins301 Chp15 –Part1


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Whole Life Insurance

  • If insured dies,

    • beneficiaries receive face amount

      = death protection + cash value

  • Structured so

    • cash value  over time

    • death protection  over time

Ins301 Chp15 –Part1


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Whole Life Insurance

Ins301 Chp15 –Part1


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Pricing Single Premium Whole Life

  • Apply same principles used with term insurance

  • Forecast expected cash flows to age 100

  • Find single premium

    = PV of expected cost

    • Assume

      • no expenses or profits

      • 5% interest rate

      • policy will not lapse

Ins301 Chp15 –Part1


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Pricing Single Premium Whole Life

Single Premium

Ins301 Chp15 –Part1


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Continuous Level Premium Whole Life

  • Continuous level premium

    • Same premium is paid until insured dies or reaches 100

    • Equivalent to a life annuity

  • Present value of a life annuity that pays $P starting at age 40 = 16.30 * P

  • Find P so that PV of premium payments = PV of costs

    • 16.30 * P = $22,373 ==> P = $1,372.58

Ins301 Chp15 –Part1


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Limited Payment Whole Life

  • Limited payment level premium

    • Same premium is paid for fixed number of years

    • Example: 20 years

    • Equivalent to a 20 year annuity

  • Present value of a 20-year annuity that pays $P starting at age 40 = $12.58 x P

  • Find P so that PV of premium payments = PV of costs

    • 12.58 x P = $22,373 ==> P = $1,778.45

Ins301 Chp15 –Part1


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Comparison of Cash Values in Whole Life

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How Much Life Insurance Should be Purchased?

  • Rules of thumb

    • Death benefit = 8 times income

  • Forecast beneficiaries sources & uses of funds

    • Uses:

      • Living expenses

      • Education expenses

    • Sources:

      • Social security

      • Earnings

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Participating Policies

  • Can (and usually does) pay annual dividends

    • always with mutual companies

    • often with stock companies

  • Why? - premiums based on conservative assumptions

    • Key assumptions: interest rate levels and mortality rates

    • These variables are correlated across policyholders

    • Insurer’s methods of dealing with correlated risk:

      • Bear the correlated risk and hold a lot of capital

      • Share correlated risk with policyholders

  • Illustrated versus actual dividends

  • Ins301 Chp15 –Part1


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    Other Whole Life Policy Provisions

    • Surrender Options

      • Take cash value

      • Use cash value as a single premium for

        • paid up whole life

        • term policy

    • Policy loans

      • borrow against cash value

        • interest now varies with market rates

        • in 1970s & 80s, fixed rate ==> disintermediation

    • Front-end expense charges

      ==> Cash value grows slowly at first

      ==> Implicit return on savings accumulation

      initially low

    Ins301 Chp15 –Part1


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    Universal Life

    • Similar to whole life

    • Main differences:

      • Greater flexibility in premium payments

      • Cash value does not follow a fixed schedule; it varies with

        • policyholder’s premium payments

        • insurer’s expense and mortality charges

        • rate insurer uses to credit interest to cash value

          • minimum rate usually guaranteed

          • rate often linked to short term interest rates

    Ins301 Chp15 –Part1


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    Factors Affecting UL Cash Value

    Ins301 Chp15 –Part1


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    Death Benefit Options with Universal Life

    • Level death benefit (as with Whole Life)

    • Death benefit varies with cash value

    Death benefit

    Death benefit

    Cash value

    Cash value

    age

    age

    Ins301 Chp15 –Part1


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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, but varies with cash value

    Ins301 Chp15 –Part1


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    Life Insurance and Annuities (part3)

    • What is annuities

    • The purpose of annuity

    • Classification of annuity

    • Overview of annuity contracts

    Ins301 Chp15 –Part1


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    What is Annuity

    • An annuity is simply a series of periodic payments.

    • An annuity contract is an insurance policy that promises to make a series of payments for a fixed period or over someone’s lifetime

    • It is typically used as long-term retirement funding vehicles.

    Ins301 Chp15 –Part1


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    Two Periods of Annuity

    • Accumulation period

      -- the period when the policyholder pays premiums to the insurer

    • Payout period

      -- the insurer makes payments to the policyholder

    Ins301 Chp15 –Part1


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    Purpose of Annuity

    • Risk management purpose

      • Reduce the risk that savings are exhausted before the annuitant dies

    • tax-deferred saving vehicle

      • Returns earned from these contracts are not taxed until the insurer distribute them

    Ins301 Chp15 –Part1


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    Classification of Annuity

    • Immediate annuity and deferred annuity

      • Immediate

      • Deferred

        • Flexible premium deferred annuities (FPDAs)

        • Single premium deferred annuities (SPDAs)

    • Fixed annuity and variable annuity

      • Fixed annuity

      • Variable annuity

    Ins301 Chp15 –Part1


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    Overview of Annuity Contracts

    Ins301 Chp15 –Part1


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