Life Insurance
Structure, Concepts, and
Planning Strategies
Chapter 4: Life Insurance
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 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
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
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
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1.
2.
3.
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
4.
Evaluate alternative methods for handling the risk
5.
Develop strategy and product recommendations
6.
Implement the risk management plan
7.
Monitor the situation
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
Risk Avoidance

Risk Retention

Risk Reduction

Risk Sharing

Risk Transfer
◦ Simply choose not to do the risky activity
◦ Personally assume the risk
 Voluntarily
 Involuntarily (uninsurable)
◦ Loss prevention and control
 Smoke detectors
◦ Spread out the risk
 Insurance companies insure millions so the loss from one has
little affect
◦ Through deductibles and using other companies
◦ Purchase of insurance
◦ Hedging with contracts
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Three steps to managing risk
1.
2.
3.
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
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Risks
Strategies for managing the impact
Events
Impact
Personal
Private
Public
Disability
Loss of income
Increased
expenses
Savings
Family
Insurance
Worker’s
Comp
Social
Security
Illness
Loss of income
Catastrophic
hospital
expenses
Savings
Healthy
living
Health
Insurance
Long term
care
Military
benefits
Medicare,
Medicaid
Death
Loss of income
Final expenses
Savings
Estate
Planning
Insurance
Social
Security
survivors
benefits
Retireme
nt
Decreased
income
Savings
Retirement
plans
Social
security
Property
Loss
Loss of ability
to use
Smoke
detectors
P&C
Flood Ins
Federal
disaster
relief
Liability
Lawsuits and
expenses
Homeowner
s
E&O,
malpractice
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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
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◦ 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
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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
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Chapter 4: Life Insurance
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
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
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
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
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 Important
Options
Convertibility
Flexibility
Shopping for Term Policies
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
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
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
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
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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.
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Source: American Council of Life Insurance, 1998
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•
•
•
•
•
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.
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
Essential Features

Variation of Whole Life Insurance

Important Issues
 Guaranteed fixed premiums
 Guaranteed death benefit
 Offers protection plus savings
 Conservative investments
◦ 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
 Investment risk remains with the insurance company
 “Guaranteed” nature of this policy
 Appropriate for conservative person with long-term
need
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
Essential Features

Variation of Universal Life Insurance

Important Issues
 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
◦ Indexed universal life
◦
Adjustable life insurance
 High level of transparency
 Flexibility of premium payments
 Policy can be tailored to changing needs of
policyholder
 Option A and Option B
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In contrast to whole life, universal life:

Premium payments are flexible.

Death benefit is adjustable.

Investment risk shifts from insurance
company to policyholder.
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Chapter 4: Life Insurance
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Chapter 4: Life Insurance
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Premium 595
st
1 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
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
Essential Features

Variation of Variable Life Insurance

Important Issues
 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
◦ Single-premium variable life
◦
Variable-universal life
 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
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
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
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









Ownership clause
Incontestability clause
Grace period
Reinstatement clause
Non-forfeiture clause
Dividend options
Policy loans
Beneficiary provisions
Suicide clause
Simultaneous death clause
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





Accelerated death benefit
Accidental death benefit
Disability waiver of premium
Disability income rider
Family rider
Guaranteed insurability option
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•
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)
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
Basic Considerations

Distribution
◦ Will the original intent be followed
◦ After distribution control goes to the beneficiary
◦ 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
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
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
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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
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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
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
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
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•
Buy-Sell Agreement
•
Key Man Insurance
•
Split-Dollar Life Insurance
– 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.
– Used to help defray expenses incurred and
revenues lost if a critical employee dies.
– IRS has some rulings that may impact the taxation of this type of strategy
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Figure 4-6 How Do Split Dollar Policies Work
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

CAPITAL MAXIMIZING STRATEGY
LIFE INSURANCE IN AN IRREVOCABLE
TRUST

LIFE SETTLEMENT OPTIONS

LIVING DEATH BENEFITS

POLICY ILLUSTRATIONS
Chapter 4: Life Insurance
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Chapter 4: Life Insurance
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1.
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
2.
CALCULATE THE LIFE INSURANCE NEED
3.
IDENTIFY THE BEST TYPE OF POLICY
4.
SELECT THE INSURANCE COMPANY
5.
PURCHASE THE POLICY
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Table 4-5
Expense Needs Versus Sources of Income
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 ABILITY
TO FUND PREMIUM
PAYMENTS
 POLICY
SUITABILITY
Amount of death benefit needed
Duration of the need
Client factors
 POLICY
REPLACEMENT
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 FINANCIAL
 CLIENT
STABILITY
SERVICE
 REPUTATION
FOR PAYING CLAIMS
 UNDERWRITING
 POLICY
STANDARDS
PRICING
Chapter 4: Life Insurance
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Rating Agencies

A.M. BEST

Fitch

Moody’s

Standard &
Poor’s

Weiss
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Two Time-tested Methods:

Human Value Approach
Based on Client’s Income Potential

Capital Needs Analysis
Sufficient for Covering Family’s
Economic needs
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Table 4-8 Family and Financial Data for John Smith
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 Payoff
mortgage?
 Payoff debt?
 Pay for kid’s education?
 Pay for final death expenses?
 Monthly income to replace?
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enter yes or no
Payoff Mortgage?
Amount?
$175,000
Payoff Debt?
Amount?
$45,000
Pay children's education?
Amount?
$25,000
Pay final expenses?
Amount?
$15,000
monthly income?
Primary
Spouse
yes
yes
yes
no
yes
no
yes
yes
Ask the client (primary) what would you want the
insurance to cover if the spouse died? (fill in
under spouse column). Ask the spouse what they
want the insurance to cover should their spouse
die, fill in under primary.
Primary Spouse
amount?
$2,925
$1,600
time?
$12
$12
return?
8.00%
8.00%
Amount of monthly income needed?
Primary Spouse
enter amounts
net income?
$4,500
$2,500
mortgage expenses? (if paid off with Ins)
$1,400
$1,400
Debt expenses? (if paid off with ins)
$900
$0
amount save for education?
$75
$0
change in child care costs?
$500
$500
any other changes in expenses?
$300
$0
minimum needed to replace income
$2,925
$1,600
Coverage needed
Mortgage
Debt
Education
Final expenses
Primary Spouse
$175,000 $175,000
$45,000
$0
$25,000
$0
$15,000 $15,000
Monthly Income
$270,220 $147,812
Approx. amt of ins needed
Current Insurance Coverage
Insurance Shortfall
$530,220 $337,812
$150,000 $80,000
-$380,220 -$257,812
Financial planning / life insurance needs
Chapter 4: Life Insurance
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•
Only cover what needs to be covered
–Need a policy to cover mortgage and
debts
• Paid off in 15 years
–Need to cover kids education
• Youngest will finish in 20 years
–Need a policy to cover income needs for
surviving spouse until they retire 30 years
from now or at least until they can find a
way to replace the lost income.
Chapter 4: Life Insurance
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