Chapter 9 The Role of Life and Health Insurance
Insurance: Planning and Control • Life insurance marketing is very confusing –recommendations and policy language differ. • Medical care is costly and sophisticated, with little incentive to economize costs. • Employers, employees, and the unemployed face increasing costs and restrictions on health care.
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
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
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 Term Insurance • Renewable term insurance • “Reentry” term insurance • Decreasing term insurance • Group term insurance • Credit or mortgage group life insurance • Convertible term life 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
Contract Clauses and Riders To Meet Your Need • Understanding 10 common features of most policies • Choosing a settlement option • Life annuity settlements • Choosing riders that meet your needs
#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.
Settlement Options (cont’d) • Installment-payments settlement -- periodic payments, normally for a fixed period, of both the principal and interest. • Life annuity settlement -- periodic payments of both the principal and interest that continue for the life of the beneficiary. • Note: Life insurance death benefits are income tax-free; however, in some cases state inheritance taxes may apply.
Types of Life Annuity Settlements • Straight life -- largest monthly payout • Straight life with period certain annuity • Straight life with refund annuity • Joint life and survivorship annuity
Riders -- The Special Provisions • Waiver of premium for disability rider • Accidental death benefit rider or multiple indemnity • Guaranteed insurability rider • Cost-of-living adjustment (COLA) rider • Living benefits rider
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
1. Buyer Beware -- A Little Knowledge Goes a Long Way • Determine your needs • Consider your needs relative to the basic products • Determine what kind of policy you want and buy it
2. Select A High-Quality Company Based on Ratings • Know your state protection • Check the ratings for the company’s financial strength and ability to pay off claims • A.M. Best • Duff and Phelps • Moody’s Investor Service • Standard & Poor’s
3. Select an Insurance Agent • Get recommendations from friends or professionals • Consider training, designations, and experience • Interview agents and get quotes on your insurance plan • Select an agent with whom you feel comfortable
4. Compare Costs of Competing Policies • The traditional net cost (TNC) method • (premiums - dividends - cash value) / number of years = TNC • does not consider the time value of money • The interest-adjusted net cost (IANC) method, or surrender cost index • considers the time value of money
5. Consider Alternative Approaches • Consult a premium quote service on the web • Buy life insurance directly from the company • Buy low-load cash-value life insurance • Consult a fee-only insurance 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.
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.
Identifying the Various Health Care Providers • Private health care plans • Non-group (individual) coverage plans • Government-sponsored health care plans
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.