Chapter 10 Life Insurance Planning and Purchasing Decisions

1. Chapter 10Life Insurance Planning and Purchasing Decisions Appropriate amount and type of insurance Measuring the cost Issues with Illustrations and Replacement Substandard coverage Viatical agreements and Life settlements Business uses of life insurance Tax treatment of life insurance Life insurance in estate planning

2. Determining Amount of Life Insurance Need Multiple of Income Approach - simplistic approach to life insurance planning that determines life insurance needs based on the client�s current annual income Human Life Value Approach � capitalizing the present value of a person�s estimated future income that will be used to support those dependent on that income

3. Determining Amount of Life Insurance Need Financial Needs Analysis � an approach to determine how much life insurance a client needs if the principal sum is to be liquidated in meeting the client's financial objectives for his or her survivors Capital Needs Analysis - an approach to determine how much life insurance is needed to provide a principal sum adequate to fund survivors� needs while preserving the principal

4. Financial Needs Lump-sum (Cash) Needs Final illness costs Outstanding debt Estate administration and taxes Probate and legal expenses Funeral, burial, etc. Short-term living and household expenses Emergency fund

5. Financial needs Ongoing Income Needs Readjustment income Dependency period- minor children Blackout period- period between when youngest child turns 16 and spouse turns 60 Surviving Spouse income with social security and pension

6. Financial Needs Analysis Identify lump-sum and ongoing income needs Identify resources Needs � resources = deficit Calculate deficit for each period Determine NPV (net present value) of the deficit for each period using appropriate discount rate Life insurance in that amount funds previously unfunded objectives

7. Example: The Stringers

8. Capital Needs Analysis Complete a financial needs analysis to determine capital needs Determine client�s net worth Subtract illiquid assets (not used for income) Subtract lump-sum needs Needs � resources = deficit Deficit/applicable interest rate Resulting capital sum will produce enough income to meet the deficit without liquidating capital fund

9. Choosing Type of Insurance Term features Temporary coverage Low initial premium Rising premium Margin for adverse selection Level, increasing, or decreasing death benefits Appropriate use of term Hedge a loan Offset speculative business investment Dependent children

10. Buy Term and Invest the Difference? Safety of principal and income Rate of return Liquidity Assurance that saving will be done (forced saving)

11. Choosing Type of Insurance Length of the planned premium-paying period Emphasis on saving vs. protection When death benefits are needed Desire for inflation protection Importance of yield vs. safety in savings Unbundling of cost components Premium flexibility

12. Measuring Cost of Insurance Surrender cost index estimates the net cost of life insurance on a time-value-adjusted basis, assuming the policy will be surrendered at a specified time (10 or 20 years) Net payment cost index estimates the net cost of life insurance on a time-value-adjusted basis assuming that the death benefit will be paid at a specified time period (10 or 20 years)

13. Life Insurance Illustrations Tables or graphs depicting a policy�s performance over a period of years Includes nonguaranteed elements. Company makes assumptions about future performance They are of limited value for comparing different policies NAIC model regulation prohibits inappropriate use of illustrations, requires annual reports on universal life policies

14. Replacement Replacing existing life insurance policy with another To prevent financial harm to the policyowner, agents and insurers must follow prescribed procedures Includes 1035 exchanges Issues in replacement pay high first-year expenses again? higher premium? new suicide clause? new incontestable clause? more or less favorable policy terms?

15. Section 1035 Exchange Defers tax implications of policy replacement Old and new contract must cover same insured and have same policyowner Life contract may be exchanged for annuity, annuity may be exchange for life insurance, but annuity may not be exchanged for life insurance Must follow certain required procedures, such as life to life, life to annuity, annuity to annuity

16. Substandard Coverage Methods Rate-up age method bases premium rate and policy values on an age older than the actual age. Used when extra mortality is increasing. Increases policy values Extra percentage tables separate, higher-than-normal mortality rates are used in calculating the premium when hazard is increasing. Normally no change in policy values Flat extra premium charging a specified extra premium per $1,000 of insurance regardless of age. Normally temporary. No change in cash values or dividends. Extra mortality is constant Lien death proceeds are reduced if death occurs within the first few years of coverage. Often prohibited by state law.

17. Viatical Agreements and Life Settlements Viatical settlement- sale of a life insurance policy where insured is terminally ill and doctor-certified to have less than 2 years life expectancy. Policyowner sells policy to third party for more than cash value but less than face amount. New owner responsible for premium payments and receives death benefit payable. Life settlements involve sale of policy to investors or others where terminal illness is not a factor. Can raise cash for seniors who need cash but no longer need, want or can afford life insurance Raises ethical issues, with much state regulatory activity currently (STOLI, IILI)

18. Business Insurance Key Employee Insurance - protects a business against possibility of income loss and/or expense increase following a key employee�s death Employer owns policy and is beneficiary. Premium not tax-deductible Buy-Sell Agreement - a contract binding the owner of a business interest to sell the business interest for a specified or determinable price at his or her death or disability and a designated purchaser to buy at that time

19. Buy-Sell Agreements Entity Agreement - a business buy-sell agreement in which the business itself is the designated purchaser of the deceased's business interest Cross-Purchase Agreement - a business buy-sell agreement in which the surviving co-owners will be the purchasers of the business interest of a deceased owner

20. Section 79 Plans Employer-sponsored group life plans that permit the employer to take a tax deduction on premium payments for coverage up to $50,000 if plan is not discriminatory Coverage above $50,000 is taxable income for employees based on premium rates specified in Table I by the IRS

21. Split-Dollar Life Insurance A plan under which two parties, usually an employer and an insured employee, share the premium costs, death proceeds, and perhaps cash value of a life insurance policy pursuant to a prearranged agreement If employee owns policy, employer paid premiums treated as loans. Employee pays market-interest rate If employer owns policy and pays premium, employee pays tax on economic benefit on value of life insurance protection and employee�s interest in cash value increases

22. Tax Treatment of Life Insurance Death Benefits Generally not taxable income to beneficiary Exceptions Transfer for value rule (policy transferred for valuable consideration) Failing IRS definition of life insurance Living benefits Dividends, withdrawals, policy loans, and cash surrender Returns exceeding policyholder�s basis taxable Inside buildup not taxable 1035 exchange not taxable

23. Income Tax Definition of Life Insurance Cash Value Accumulation Test- determines if a life insurance policy meets the definition of life insurance for federal income tax purposes. To qualify, the cash value must not exceed the net single premium needed to fund the policy's death benefit. Guideline Premium and Corridor Test �a two-pronged test determines if a life insurance policy meets the definition of a life insurance policy for federal income tax purposes. The test relates to both the size of the total premium paid and the size of the death benefit relative to the cash value.

24. Tax Treatment of Life Insurance Inside Buildup - the increase in the cash value or investment fund of a permanent life insurance policy is not taxable while in the policy Modified Endowment Contract (MEC) - a life insurance policy that fails to meet the IRC�s 7-pay test. Distributions receive less favorable tax treatment than other life insurance contracts. MEC�s taxed like an annuity

25. Tax Treatment of Life Insurance Deductibility of Premium Payments Generally, premiums for personally owned individual life insurance is not tax-deductible Three situations in which life insurance premiums may be deductible Charitable contribution Employer sponsored benefit (if taxable to employee) As part of Alimony for ex-spouse

26. Transfer Taxation - Gift Tax Gift tax- a tax imposed on transfers of property by gift during the donor's lifetime Gift - for federal gift tax purposes, a completed transfer and acceptance of property for less than full and adequate consideration Annual Exclusion - the amount of a gift exempt from federal transfer taxation (for 2008, $12,000). Can be doubled if the donor is married and the donor's spouse elects to split the gift (2008- $24,000)

27. Transfer Taxation - Estate Tax Estate tax - a tax imposed by the federal government and many states on the right of a person to transfer property at death Gross Estate - for federal estate tax purposes, the property of a decedent that passes by will and by other means Incident of ownership - any right to the economic benefits of a piece of property, such as a life insurance policy

28. Life Insurance in Estate Planning Federal Estate Taxation of Life Insurance Life insurance included in the estate if: proceeds payable to the estate or executor insured had incidents of ownership insured had incidence of ownership on transferred policy within 3 years of death

29. Life Insurance in Estate Planning Techniques using Life Insurance in Estate Planning Gifts of life insurance policies to ILIT (Irrevocable life insurance trust) or family member. Prevent estate inclusion using annual exclusion Providing estate liquidity, pay estate expenses Enhance estate value Wealth replacement Use of second-to-die policies (for unlimited marital deduction)

30. Annuities - Chapter 11 Nature and Types of annuities Joint annuities Variable annuities Indexed annuities Actuarial considerations, fees and charges Federal income tax treatment Uses of annuities Ethical issues Uses of annuities in structured settlements Impaired risk annuities

31. Types of Annuities Annuity - a periodic payment to begin at a specified or contingent date and continue for a fixed period or for the duration of a designated life or lives Annuitant - the person whose life governs the duration of benefit payments under a life annuity

32. Types of Annuities Annuity certain - an annuity with benefit payments that continue for a definite period of time without being linked to the duration of a specified human life (fixed period annuity Life (whole life) annuity - an annuity whose benefit payments continue for the duration of a designated life Temporary life annuity - an annuity whose benefit payments continue until the earlier of the death of a designated person or the end of a specified period of time. The term life with annuity indicates a life contingency

33. Life Insurance versus Annuities Life insurance Protect against loss of income from premature death Pooling�those who live longer subsidize those who don�t Premiums based on mortality table focusing on probabilities of death Premiums discounted for future interest earnings Annuities Protect against loss of income from longevity Pooling�those who die early subsidize those who live long Different mortality table- annuitants live longer. Focuses on probability of surviving Premiums (deposits) discounted

34. Types of Annuities Joint (joint-life) annuity - benefit payments continue only until the first death among specified lives (rarely used) Joint-and-last-survivor annuity - benefit payments continue until the last death among specified lives

35. Types of Annuities Immediate annuity - benefit payments begin one payment interval after the date of purchase Deferred annuity - benefit payments begin more than one payment interval after the date of purchase Accumulation period - period during which premiums (deposits) are paid to the insurer Liquidation period - period during which benefits are paid by the insurer

36. Types of Annuities Pure (straight life) annuity - provides no guaranteed minimum number of benefit payments or refund of the purchase price; pays for life of the annuitant; stops at death. Provides highest payout and greatest risk. Also called life-no refund annuity Refund annuity - promises to return a portion or all of the purchase price or to provide a guaranteed minimum number of benefit payments, no matter how early in the liquidation period the annuitant dies

37. Types of Annuities Installment refund annuity - if the annuitant dies before receiving total benefit payments equal to the purchase price of the annuity, the difference will be refunded in the form of continuing benefit payments Cash refund annuity - if the annuitant dies before receiving total benefit payments equal to the purchase price of the annuity, all or a stated percentage of the difference will be refunded in cash 

38. Types of Annuities Fixed annuity - provides a stated periodic dollar benefit regardless of the insurer's investment return Variable annuity - benefit payments vary with changes in investment performance Life annuity certain - provides a guaranteed minimum number of benefit payments whether the annuitant lives or dies. Combines an annuity certain and a pure deferred life annuity. Also called period-certain

39. Annuity Contract Design Premiums quoted in $100 of annual premium or per $10 of monthly income Minimum guaranteed rate of interest Secondary higher guaranteed rate (for first several years) Cash withdrawals may reduce secondary rate Bail-out provision (% drop in rate allows withdrawal) Cash option (withdrawal or partial surrender - allows an annuitant, at the start of the liquidation period, to withdraw the funds in cash rather than as an annuity

40. Variable Annuity Contract Accumulation units - number of units bought and value of each unit vary depending on when purchases are made. Units reflect market value, like NAV of mutual fund shares Annuity units - number of annuity units distributed periodically is constant, but their value varies depending on company assumptions regarding mortality, expense and investment experience. Units revalued annually to determine life income per unit for coming year

41. Indexed Annuity Guarantees a minimum fixed rate of interest credits but also provides higher credits if a specified common stock index rises sufficiently Many variations in products regarding Participation rates Cap rates Indexing formula Possible SEC regulation requiring product to be treated as a security

42. Annuity Mortality Purchasers of annuities have generally lower mortality rates than others (adverse selection). Mortality rates for most people, including annuitants, have been declining. A high percentage of annuitants are women, who have greater average longevity than men.

43. Fees and Charges Mortality and expense charge Investment management fee Administrative or maintenance fee Front-end load Surrender charge (back-end load)

44. Federal Income Tax Treatment Amounts received during accumulation period Taxable to the extent of income earned (LIFO) 10% tax on withdrawals before 59 � Amounts received during liquidation period Depends on exclusion ratio � amount invested/the amount expected to be received as life annuity. Amount excluded ratio x payment = tax-free return of principal. Excluded amount, presumed to be return of investment, is not taxable Balance is taxable

45. Annuity Uses Those seeking to accumulate an estate or hedge against adverse financial developments Those seeking guaranteed income, especially retirement Charitable gift annuities - can meet three goals: contributing to religious, educational, or other charitable organization providing life income for annuitant(s) minimizing taxes Impaired-risk annuities - increased annuity payments (or reduced premiums) reflect annuitant�s reduced life expectancy due to injury or poor health

46. Ethical Issues Insurance producer and/or insurer should have reasonable grounds for believing the proposed annuity is suitable for the consumer based on facts the consumer provides concerning financial status tax status investment objectives other reasonable information There is regulatory concern about suitability for older clients, especially with variable annuities

47. Charitable Gift Annuity Charitably-inclined client donates cash or other asset to charity. Charity pays annuity income for life of annuitant to donor or other beneficiary (called a charitable lead trust) Client entitled to immediate tax deduction for irrevocable gift to charity based on value of gift and IRS annuity tables that determine present value of annuity based on age and federal interest rate, like exclusion ratio.

48. Structured Settlement An agreement to pay a specified set of periodic benefits in lieu of (or in addition to) a single, lump-sum amount Used when settling liability claims for bodily injury or wrongful death Provide financial security, management of benefits, guaranteed payout, and benefits that can be matched to need (court order)

49. Self-Test Questions Chapter 10 Using a simple multiple of earnings method to determine the amount of life insurance needed ignores key information about how much a client has already accumulated. 2. The financial needs analysis approach considers both lump-sum needs at death and ongoing income needs. 3. With the financial needs analysis approach, the amount of additional life insurance needed is determined by subtracting the resources already available from the resources needed by the surviving dependents if the client should die today, assuming all future income payments are composed solely of investment earnings on a capital sum. A major advantage of the financial needs analysis approach is that it fails to take into account factors that may be difficult to forecast, such as Social Security benefits and future earnings by a spouse. 5. Although term insurance is available in the marketplace, virtually all client life insurance needs are best met with whole life insurance.

50. Self-Test Questions Chapter 11 1. The person whose life governs the duration of payments in an annuity is called the annuitant. 2. Annuities serve essentially the same function as life insurance. 3. If Jack would like to accumulate money for his planned retirement in 20 years, he should purchase an immediate annuity with periodic premiums. 4. If Rachel purchased a life annuity with 20 years certain to liquidate her retirement savings and was still alive at the end of 20 years, her annuity benefit payments would cease. 5. An installment refund annuity promises to keep paying installment benefits to the annuitant and/or beneficiary until the total equals the purchase price of the annuity plus interest at a guaranteed rate.