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CHAPTER 4

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CHAPTER 4

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  1. CHAPTER 4 Life Insurance Structure, Concepts, and Planning Strategies Chapter 4: Life Insurance

  2. Financial Services • There are 3 basic markets in financial services (Byerly) • Wealthy • About 3 – 4% of the population • Middle America • 25K – 100K household • Low income • Little need for financial services Chapter 4: Life Insurance

  3. Business Philosophy (Byerly) • Gear marketing efforts at the wealthy • Higher profit potential per client • Fewer clients • Complex financial situations • Taxes • Estate planning • Focus on Middle America • Many more clients • Less profit per client • Simpler needs Chapter 4: Life Insurance

  4. INTRODUCTION TO THE RISK MANAGEMENT PROCESS • Identify the nature and cause of the risk • Assess probability of loss and amount of potential loss • Understand weaknesses of the current risk management plan • Evaluate alternative methods for handling the risk • Develop strategy and product recommendations • Implement the risk management plan • Monitor the situation Chapter 4: Life Insurance

  5. THEORY OF RISK TRANSFER: HANDLING RISK • Risk Avoidance • Simply choose not to do the risky activity • Risk Retention • Personally assume the risk • Voluntarily • Involuntarily (uninsurable) • Risk Reduction • Loss prevention and control • Smoke detectors • Spread out the risk • Insurance companies insure millions so the loss from one has little affect • Risk Sharing • Through deductibles and using other companies • Risk Transfer • Purchase of insurance • Hedging with contracts Chapter 4: Life Insurance

  6. Personal Risk Management: An Overview • Three steps to managing risk • Identify nature and cause of the risk • Determine how much if any risk you are willing to assume • Determine the best technique for handling the risk Chapter 4: Life Insurance

  7. Risk Management Strategy Chapter 4: Life Insurance

  8. Risk Management Strategies Chapter 4: Life Insurance

  9. Types of Insurances Available Chapter 4: Life Insurance

  10. INTRODUCTION TO LIFE INSURANCE Key reason for buying life insurance is to meet financial obligations in order to: • Pay off final expenses, estate taxes, state inheritance taxes, and administration costs • Provide for spouse, children, and other dependents • Provide funds for education • Provide for a legacy to heirs or charity • Pay off all debts and mortgages Chapter 4: Life Insurance

  11. Other Uses of Life Insurance • Transfer ownership of business or protect business against loss of key employees • Maintain adequate emergency fund • Very ineffective • Provide insurance for ex-spouse • Provide funds for charity • Create salary continuation plan for employees • Finance company’s obligations under continuation plan Chapter 4: Life Insurance

  12. Purchasing Life Insurance In Purchasing Life Insurance: • Main objectives are to determine how much insurance to purchase, and which type of insurance offers best value. • Secondary objective is to treat life insurance as a form of savings. • Very poor investment vehicles Chapter 4: Life Insurance

  13. Theory of Decreasing Responsibility Chapter 4: Life Insurance

  14. TERM INSURANCE • Essential Features • Rented for a specified time • Verbage to make it sound like a bad choice • Just like auto insurance • If renewable, can be renewed upon expiration • Premiums lower in earlier years, but jump dramatically later • Better phrased: as we get older any continuation will cost more • But if we want to increase coverage any insurance will cost more later than now • Provides pure protection with no savings Chapter 4: Life Insurance

  15. TERM INSURANCE • Types of Term Insurance • Level Term • 10 – 35 year terms • Renewable Term • Annual some 5 year • Convertible Term • May be more expensive than straight term • May have to prove insurability but may be able to “buy” guaranteed insurability • Usually increase in cost or reduction in face value at conversion • Decreasing Term • Credit life insurance • Very expensive • Usually not necessary Chapter 4: Life Insurance

  16. TERM INSURANCE • Important Options • Convertibility • Flexibility • Shopping for Term Policies Chapter 4: Life Insurance

  17. CASH VALUE INSURANCE • Essential Features • Death protection • Of course no such thing • Income protection better phrase • Permanence • Do you need it forever? • Level Premiums (Figure 4-3) • Cash value (Figure 4-4) • Cash value is the amount in the investment account after all expenses paid and any investment return has been added Chapter 4: Life Insurance

  18. Cash Value Insurance • Essential Features • Flexibility • Loans (bad idea) • Do you have to pay yourself back? • Paid up policies; if you want tostop paying premiums • Same face for a specific time • Reduced face for a specific period of time • Level Premiums (Figure 4-4) • Dividend Option (more on this later) • Emergency Fund Chapter 4: Life Insurance

  19. Comparison of Level Premiums Comparison of Level Premiums for $1,000 Insurance How much would you pay per month for a $100,000 policy? This figure is misleading in it’s attempt to convince you that term insurance is a bad choice. You can buy 35 year fixed term. Chapter 4: Life Insurance

  20. People are Over-Premiumed and Under-Insured Source: American Council of Life Insurance, 1998 Chapter 4: Life Insurance

  21. What does the difference mean? • Whole life policy $100,000 at age 30 costs average of 100 * $17.12 = $1,712 per year. • Term 100 * $2.58 = $258 • Invest the difference for 35 years at 12% ($1,454) • End investment value = $627,638 • A whole life policy can never exceed it’s face value without endowing. This could create tax issues. Chapter 4: Life Insurance

  22. WHOLE LIFE INSURANCE • Essential Features • Guaranteed fixed premiums • Guaranteed death benefit • Offers protection plus savings • Conservative investments • Variation of Whole Life Insurance • Limited-Pay Whole Life • Modified or Graded-Premium Whole Life • Single-Premium Whole Life • Endowment Life • Current Assumption Whole Life • Return-of-Premium Whole Life • Important Issues • Investment risk remains with the insurance company • “Guaranteed” nature of this policy • Appropriate for conservative person with long-term need Chapter 4: Life Insurance

  23. Cash Value Policies Chapter 4: Life Insurance

  24. UNIVERSAL LIFE INSURANCE • Essential Features • Premium payments (timing and amounts) are flexible • Debt benefits is adjustable • Investment risk shifts from insurance company to the policyholder • Unbundling of expenses and cash value accounts • Variation of Universal Life Insurance • Indexed universal life • Adjustable life insurance • Important Issues • High level of transparency • Flexibility of premium payments • Policy can be tailored to changing needs of policyholder • Option A and Option B Chapter 4: Life Insurance

  25. UNIVERSAL LIFE In contrast to whole life, universal life: • Premium payments are flexible. • Death benefit is adjustable. • Investment risk shifts from insurance company to policyholder. Chapter 4: Life Insurance

  26. How Universal Life Insurance Works Chapter 4: Life Insurance

  27. UL Chapter 4: Life Insurance

  28. Premium 595 1st year Charges 2.35% + 1.25% + 4% = 7.6% 45.22 + 240 + 96 = 381.22 (64%) After first year $141 (23.7%) Does not include costs of insurance Chapter 4: Life Insurance

  29. VARIABLE LIFE INSURANCE • Essential Features • Cash value and death benefit based on investment performance of separate account • Minimum death benefit paid as long as premiums paid • Investment risk shifts from insurance company to the policyholder • Variation of Variable Life Insurance • Single-premium variable life • Variable-universal life • Important Issues • Policyholder makes the investment decisions • Investment choices include: equity mutual funds, fixed income mutual funds and money market instruments • Appropriate for policyholder with investment acumen Chapter 4: Life Insurance

  30. Other Life Insurance Policies • SURVIVORSHIP LIFE POLICY • First-to-Die Policies • Second-to-Die Policies • Ownership Options • Accelerated Death Benefits • Living Death Benefits • FAMILY INCOME • INSURANCE FOR INDIVIDUAL FAMILY MEMBERS • Spousal Insurance • Insurance for Children Chapter 4: Life Insurance

  31. Life Insurance Contract • Ownership clause • Incontestability clause • Grace period • Reinstatement clause • Non-forfeiture clause • Dividend options • Policy loans • Beneficiary provisions • Suicide clause • Simultaneous death clause Chapter 4: Life Insurance

  32. Life Insurance Policy Riders • Accelerated death benefit • Accidental death benefit • Disability waiver of premium • Disability income rider • Family rider • Guaranteed insurability option Chapter 4: Life Insurance

  33. LOANS FROM LIFE INSURANCE POLICY • Net Borrowing Cost • Ignores Opportunity Cost • Must pay back the loan or the interest continues • Reduces Death Benefit • Taxed at Highest Rate if it Violates 7-Pay Test • Desirable if Alternative Sources Not Available (absolute last resort) Chapter 4: Life Insurance

  34. LIFE INSURANCE SETTLEMENT OPTIONS • Basic Considerations • Will the original intent be followed • After distribution control goes to the beneficiary • Distribution • Lump-Sum Payment: Tax-Free • Fixed Annuity: Partially Taxable • “annuitization” • Control of money goes to insurance company • Fixed Period Option • Fixed Income Option • Life-income Option Chapter 4: Life Insurance

  35. SETTLEMENT OPTIONS • Annuitization • The process of converting from a lump sum into some form of a payment stream • Insurance company “insures” the payment stream • Insured loses control of the assets • PMT for Life • What if die in 3 years • Insurance company keeps the rest • Period certain • The insurance company guarantees a certain # of payments • 10 year certain • If die in 15 years the insurance company pays until you die • If die in 5 years, the insurance company would pay to a beneficiary the amount that would have been received for 10 years, the insurance company would keep any excess Chapter 4: Life Insurance

  36. Taxation • TAXATION OF LIFE INSURANCE • Distribution upon Death • Usually not taxable • Distribution during Life • Dividends not taxable • Loans could be taxable • Cashing out could be taxable • LIFE INSURANCE AND ESTATE TAXES • If the owner, policy included in estate Chapter 4: Life Insurance

  37. Switching • SWITCHING LIFE INSURANCE POLICIES • Replacement should be watched carefully • CV to CV could be churning • Term to CV • Convertible not really a switch • CV to term • Special reporting requirements Chapter 4: Life Insurance

  38. BUSINESS USES OF LIFE INSURANCE • Buy-Sell Agreement • Key Man Insurance • Insurance for Professionals • Group Life Insurance • Split-Dollar Life Insurance • Life Insurance in Qualified Plans • Section 412(i) Plan • Life Insurance in Non-Qualified Plan • Welfare Benefit Trust Chapter 4: Life Insurance

  39. Buy-Sell Agreement • Partners would have insurance on other partners. If a partner dies, the others receive a death benefit that they use to buyout the business interest from the deceased partner’s beneficiaries. • Key Man Insurance • Used to help defray expenses incurred and revenues lost if a critical employee dies. • Split-Dollar Life Insurance • IRS has some rulings that may impact the taxation of this type of strategy Chapter 4: Life Insurance

  40. Split Dollar Policies Figure 4-6 How Do Split Dollar Policies Work Chapter 4: Life Insurance

  41. MISCELLANEOUS LIFE INSURANCE ISSUES • CAPITAL MAXIMIZING STRATEGY • LIFE INSURANCE IN AN IRREVOCABLE TRUST • LIFE SETTLEMENT OPTIONS • LIVING DEATH BENEFITS • POLICY ILLUSTRATIONS Chapter 4: Life Insurance

  42. How a Life Insurance Trust Works Chapter 4: Life Insurance

  43. LIFE INSURANCE PLANNING • UNDERSTAND THE CLIENT’S GOALS • Income replacement • Pre-funding children’s education • Pay off debts • Provide for final expenses and taxes (liquidity) • Leaving a legacy • CALCULATE THE LIFE INSURANCE NEED • IDENTIFY THE BEST TYPE OF POLICY • SELECT THE INSURANCE COMPANY • PURCHASE THE POLICY Chapter 4: Life Insurance

  44. Expense Needs Versus Sources of Income Table 4-5 Expense Needs Versus Sources of Income Chapter 4: Life Insurance

  45. POLICY SELECTION OR REPLACEMENT • ABILITY TO FUND PREMIUM PAYMENTS • POLICY SUITABILITY • Amount of death benefit needed • Duration of the need • Client factors • POLICY REPLACEMENT Chapter 4: Life Insurance

  46. INSURANCE COMPANY SELECTION • FINANCIAL STABILITY • CLIENT SERVICE • REPUTATION FOR PAYING CLAIMS • UNDERWRITING STANDARDS • POLICY PRICING Chapter 4: Life Insurance

  47. RATINGS OF INSURANCE COMPANIES Rating Agencies • A.M. BEST • Fitch • Moody’s • Standard & Poor’s • Weiss Chapter 4: Life Insurance

  48. DETERMINATION OF LIFE INSURANCE NEEDS Two Time-tested Methods: • Human Value Approach Based on Client’s Income Potential • Capital Needs Analysis Sufficient for Covering Family’s Economic needs Chapter 4: Life Insurance

  49. Determination of Life Insurance Need Chapter 4: Life Insurance

  50. INSURANCE NEEDS EXAMPLE:Gathering Data Table 4-8 Family and Financial Data for John Smith Chapter 4: Life Insurance