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Chapter 9. The Role of Life and Health Insurance. Understanding the Logic Behind Insurance. Insurance is an example of risk pooling -- individuals share their financial risks to reduce catastrophic losses from death, accidents, or health problems. Life Insurance Policy Terms.

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Chapter 9

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Chapter 9

The Role of Life and Health Insurance


Understanding the Logic Behind Insurance

  • Insurance is an example of risk pooling -- individuals share their financial risks to reduce catastrophic losses from death, accidents, or health problems.


Life Insurance Policy Terms

  • Premium -- the monthly cost of the policy

  • Face value -- the benefit due upon death

  • Insured -- the person whose life is covered by the policy

  • Policy owner -- the individual or business that pays for and owns the policy

  • Beneficiary -- the recipient of the benefit upon the death of the insured


Life Insurance May Not Be Necessary for the Following

  • Single person, without dependents

  • Double-income married couple, without dependents

  • Married, but unemployed, individual without dependents

  • Retired persons


Life Insurance May Be Necessary for Those

  • With dependents

  • Who are a married, single-income couple, with children

  • Who are business owners?

  • Whose estate exceeds the estate tax-free transfer threshold ($675,000 in 2000/2001 and increasing to $1M by 2006).


Determine Your Life Insurance Needs: Two methods

  • The earnings multiple approach

    • To replace the annual salary stream of a bread winner for X years, normally 5 – 15 times gross salary is recommended.

  • The needs approach

    • To meet the needs of the household after the death of a breadwinner, both current and in the future.


The Earnings Multiple Approach

  • Adjust salary down to compensate for the reduction in household expenses.

  • Choose the PVIFA i%, n yr to match the assumed after-tax and after-inflation earnings on the policy settlement.

  • The longer the income stream replacement, the greater the multiple. The higher the assumed earnings, the lower the multiple.


Earning Multiple Approach Formula

Life Insurance Needs =

Income x (1 – % of income spent on the deceased) x PVIFA i%, n yr

Assume earning $75,000, less $25,000 for remaining 30 years at 5 %, how much insurance should one have?


The Needs Approach -- The Seven Funds

  • Immediate needs funds

  • Debt elimination funds

  • Immediate transitional funds

  • Dependency funds

  • Spousal life income funds

  • Educational funds for child or spouse

  • Retirement income funds


The Needs Approach -- The Calculation

  • Add all funding needs to determine total need

  • Subtract current insurance coverage and other available assets

  • This determines amount of additional insurance coverage necessary


Needs Approach

  • Bill age 35 and Mary age 33 seek your advice on the amount of life insurance to purchase. They have two children ages six and four.

  • Bill earns $65,000 per year in salary.

  • Their home is worth $150,000 and they have a $90,000 mortgage.

  • Their savings and investments total $30,000.

  • Mary currently does not work and would find it difficult to go to work until the youngest child enters first grade in two years.

  • She anticipates she could earn $40,000 after taxes at that time which would handle all her needs throughout her working life.


Bill and Mary Continued

  • Funeraland administrative expenses would approximate $10,000.

  • The family anticipates a current need of $100,000 to assist the children with college education.

  • Mary acknowledges that she needs an additional 8,000 per year per child to cover expenses until the children are off the nest.

  • Assume $45,000 of Bill’s salary is devoted to the family and 8% is an appropriate rate of return.

  • How muchinsurance does Bill need?


Major Types of Insurance

  • Term insurance

  • Cash-value insurance


Term Insurance

  • Death benefit coverage for a specific term of time

  • Only valid if the insured dies during the term of coverage

  • Least expensive form of insurance


Cash-Value Insurance

  • Provides a death benefit and an opportunity to accumulate savings

  • Provides permanent insurance


Types of Cash-Value Insurance

  • Whole life insurance – for those who need permanent life insurance protection

  • Universal life insurance – for those who want a flexible policy that combines term protection and tax-deferred savings

  • Variable life insurance – for those who want to take risks and manage their own investments with an opportunity for tax-deferred savings.


Whole Life Insurance and Its Features

  • Permanent protection

  • Fixed premium

  • Fixed death benefit

  • Fixed cash-value that grows tax-deferred

  • Much less death protection than term for the same price

  • Yield on cash value portion is not competitive with yields on alternative investments


Universal Life Insurance and Its Features

  • Permanent protection

  • Flexible premium payments with unbundling

    • mortality charge or term insurance

    • cash value or savings

    • administrative expenses

  • Flexible death benefits

  • Cash-value fluctuates depending on the amount paid into the policy


Universal Life Insurance and Its Features (cont’d)

  • Returns fluctuate widely

  • Policies often lapse because of the flexibility to not make premium payments

  • Savings may not accumulate as expected due to fluctuations in return and high expense charges


Variable Life Insurance and Its Features

  • Permanent protection; returns are earned on a tax-deferred basis

  • Allows for either a fixed (straight variable) or flexible (variable universal) premium

  • Flexible death benefit and fluctuating cash value, reflecting the mutual fund investment performance


Determining Which Type of Insurance Is Right for You

  • For most, term is the best alternative.

    • Relatively low cost

    • Affordable coverage when life insurance is needed the most

    • Can afford to carry the coverage needed

    • Becomes very expensive with age, but may be unnecessary


Determining Which Type of Insurance Is Right for You

  • Cash-value insurance offers tax advantages

    • Savings grow tax-deferred and are passed on without incurring estate taxes

    • Other investment plans are better relative to cash-value insurance


#1. The Beneficiary Provision

  • Allows for the naming of primary and contingent beneficiaries.

  • May name an irrevocable beneficiary that cannot be changed without permission of the beneficiary.


#2. The Grace Period Clause

  • Automatic extension of 30 or 31 days that the owner has to pay the premium without the policy lapsing.


#3. The Loan Clause

  • Only exists on policies with a cash value.

  • Allows the owner to borrow against the cash value of the policy.


#4.The Nonforfeiture Clause

  • Provides options for policy holders to terminate their policies early

    • receive the cash value

    • exchange cash value for a paid-up policy with a reduced face value

    • exchange cash value for a paid-up term policy with the full face value


#5. The Policy Reinstatement Clause

  • Option for restoring a lapsed policy within 3 to 5 years of the expiration

  • Generally requires all past due premiums, loans, and interest be paid before reinstatement


#6. The Change of Policy Clause

  • Allows the policy holder to change the type of policy in effect


#7. The Suicide Clause

  • States that the insurance company will not pay death benefits if the insured commits suicide within 2 years of when the policy took effect.


#8. The Payment Premium Clause

  • Explains the options available for the payment of the premiums, such as monthly or annually.


#9. The Incontestability Clause

  • Declares that the insurance company can not dispute the validity of the policy after a certain time period has passed, normally 2 years.

  • This clause provides very important protection to the beneficiary against policy cancellation.


# 10. Settlement Options

  • Lump-sum settlement -- one time payout upon death of the insured.

  • Interest-only settlement -- periodic payments of the interest earned by the principal.


Buying Life Insurance

1.Buyer beware -- a little knowledge goes a long way

2.Select a high-quality insurance company based on company ratings

3.Select an insurance agent with whom you feel comfortable

4.Compare costs of competing policies

5.Consider alternative approaches: the net or an advisor


Major Types of Health Care Coverage

  • Basic health insurance

  • Major medical expense insurance

  • Dental and eye insurance

  • Dread disease and accident insurance


Basic Health Insurance

  • Hospital insurance -- covers hospitalization expenses including room fees, nursing fees, and drug fees.

  • Surgical insurance -- covers only the direct costs of surgery including the surgeon’s fees and equipment fees.

  • Physician expense insurance -- covers physicians’ fees including office fees, lab fees, and X-ray fees.


Major Medical Expense Insurance

  • Covers medical costs beyond the basic plan.

  • Normally requires co-payments and deductible payments.

  • Stop-loss provision -- limits the total out-of-pocket expenses incurred by the insured to a specific dollar amount.

  • Life-time cap -- total amount the insurance company will pay over the life of a policy.

See examples in notes


Dental and Eye Insurance

  • Covers the costs of eye exams, glasses, contact lenses, dental work, and dentures.

  • Typically prohibitively expensive unless provided with an employer plan.


Dread Disease and Accident Insurance

  • Covers only specific illness or accidents.

  • Provides a set dollar amount of reimbursement.

  • Note: Avoid these types of insurance -- concentrate on making your health coverage as comprehensive as possible.


Private Health Care Plans

  • Fee-for-service or traditional indemnity plans

  • Managed health care

    • health maintenance organizations (HMOs)

    • preferred provider organizations (PPOs)


Fee-for-Service or Traditional Indemnity Plans

  • Provides greatest flexibility for choosing doctors and hospitals.

  • Coinsurance -- defines the percentage of each claim that the policy will cover.

  • Co-payment or deductible -- defines the amount that you must pay before a claim is eligible for reimbursement.

  • Plans are relatively expensive and require more paperwork.


Managed Health Care

  • Pays for and provides health care services to policy holders.

  • Limits choices to the doctors and hospitals that participate.

  • Requires the policy holder to pay a monthly premium and share the cost of care.

  • Provides the most efficient payment of bills.


Group Insurance

  • Is sold to a group or employer rather than to an individual

  • Normally does not require subscribers to pass a medical exam

  • 15% - 40% cheaper than an individual policy


Government-Sponsored Health Care Plans

  • Workers’ Compensation

  • Medicare

  • Medicaid


Workers’ Compensation

  • Provides insurance to workers injured on the job

  • Provides payment for work-related accidents and illness

  • Coverage is determined by state law and varies by state


Medicare

  • Provides medical benefits to the disabled and to those 65 and older

  • Cost is covered through Social Security tax

  • Divided into two parts -- A and B

  • Part A is compulsory and covers hospital expenses


Medicare (cont’d)

  • Part B is voluntary, with a monthly premium, and covers doctors’ fees and other medical services

  • Medigap insurance, sold by private companies, provides for gaps in Medicare coverage with Parts A and B


Medicaid

  • Provides health care for low income, blind, or aged persons.

  • Payments may be used to offset the premiums, deductibles, and co-payments incurred with Medicare.


Controlling Health Care Costs

  • Live healthy

  • Use a medical reimbursement or flexible spending account

  • Consider COBRA when changing jobs

  • Choose no health care coverage -- not recommended unless necessary


Medical Reimbursement or Flexible Spending Account

  • Optional employer-established savings plan funded with pre-tax dollars.

  • Provides an account for paying unreimbursed medical expenses.

  • Use it or lose it!

  • Very flexible, but some expenses are not eligible for coverage.


COBRA and Changing Jobs

  • With a company of more than 20 employees, depending on why you leave the company, you can continue health coverage for 18 – 36 months.

  • You pay the premium.

  • Must notify the company within 60 days of leaving.


Important Provisions in Health Insurance Policies

  • Who’s covered?

  • Terms of payment

  • Preexisting conditions

    • Always maintain coverage to avoid exclusions

  • Guaranteed renewability provision

  • Exclusions

  • Emotional and mental disorders


Disability Insurance

  • Provides income (67% to 80% of after-tax income) in the event of a long-term illness or injury

  • Anyone who depends on earned income should have disability coverage


Disability Insurance (cont’d)

  • Sources of disability insurance

    • Workers’ Compensation

    • Social Security

    • Purchase through your employer’s benefit plan

  • Amount of coverage depends on the amount of income to be replaced


Disability Insurance Features That Make Sense

  • Determine the providers’ definition of disability -- make sure it is not too restrictive

  • Residual or partial payments when returning to part-time work

  • Duration of disability benefits

    • short-term disability -- 6 months to 2 years

    • long-term disability -- until age 65 to 70 or for the insured’s lifetime


Disability Insurance Features That Make Sense (cont’d)

  • Waiting (or elimination) period

  • Waiver of premium provision

  • Noncancelable provision

  • Rehabilitation coverage provision


Long-Term Care Insurance

  • Provides a daily dollar benefit for the costs of long-term care

  • Expensive, with many exceptions and conditions for coverage (e.g. ADLs)

  • Who needs it?

    • Those with savings to protect.

    • Those with a family history of long-term disabilities.


Important Long-Term Care Insurance Provisions

  • Provisions which control qualification for benefits

  • Type of care covered

  • Benefit period

  • Waiting period

  • Inflation adjustment provision

  • Waiver of premium provision

  • Noncancelability provision


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