Life Insurance Structure, Concepts, and Planning Strategies Chapter 4: Life Insurance1 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 Insurance2 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 Insurance3 1. Identify the nature and cause of the risk 2. Assess probability of loss and amount of potential loss 3. 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 Chapter 4: Life Insurance4 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 Insurance5 6 Three steps to managing risk 1. Identify nature and cause of the risk 2. Determine how much if any risk you are willing to assume 3. Determine the best technique for handling the risk Chapter 4: Life Insurance7 8 RisksStrategies for managing the impact EventsImpactPersonalPrivatePublic DisabilityLoss of income Increased expenses Savings Family Insurance Workers Comp Social Security IllnessLoss of income Catastrophic hospital expenses Savings Healthy living Health Insurance Long term care Military benefits Medicare, Medicaid DeathLoss of income Final expenses Savings Estate Planning InsuranceSocial Security survivors benefits Retireme nt Decreased income SavingsRetirement plans Social security Property Loss Loss of ability to use Smoke detectors P&C Flood Ins Federal disaster relief LiabilityLawsuits and expenses Homeowner s E&O, malpractice Chapter 4: Life Insurance9 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 Insurance10 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 companys obligations under continuation plan Chapter 4: Life Insurance11 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 Insurance12 Chapter 4: Life Insurance13 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 Insurance14 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 Insurance15 Important Options Convertibility Flexibility Shopping for Term Policies Chapter 4: Life Insurance16 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 Insurance17 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 Insurance18 Comparison of Level Premiums for $1,000 Insurance Chapter 4: Life Insurance19 How much would you pay per month for a $100,000 policy? This figure is misleading in its attempt to convince you that term insurance is a bad choice. You can buy 35 year fixed term. Chapter 4: Life Insurance20 Source: American Council of Life Insurance, 1998 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 its face value without endowing. This could create tax issues. Chapter 4: Life Insurance21 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 Insurance22 Chapter 4: Life Insurance23 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 Insurance24 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 Insurance25 Chapter 4: Life Insurance26 Chapter 4: Life Insurance27 Chapter 4: Life Insurance28 Premium st year Charges 2.35% % + 4% = 7.6% = (64%) After first year $141 (23.7%) Does not include costs of 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 Insurance29 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 Insurance30 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 Insurance31 Accelerated death benefit Accidental death benefit Disability waiver of premium Disability income rider Family rider Guaranteed insurability option Chapter 4: Life Insurance32 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 Insurance33 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 Insurance34 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 Insurance35 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 Insurance36 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 Insurance37 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 Insurance38 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 partners 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 Insurance39 Figure 4-6 How Do Split Dollar Policies Work Chapter 4: Life Insurance40 CAPITAL MAXIMIZING STRATEGY LIFE INSURANCE IN AN IRREVOCABLE TRUST LIFE SETTLEMENT OPTIONS LIVING DEATH BENEFITS POLICY ILLUSTRATIONS Chapter 4: Life Insurance41 Chapter 4: Life Insurance42 1. UNDERSTAND THE CLIENTS GOALS Income replacement Pre-funding childrens 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 Chapter 4: Life Insurance43 Table 4-5 Expense Needs Versus Sources of Income Chapter 4: Life Insurance44 ABILITY TO FUND PREMIUM PAYMENTS POLICY SUITABILITY Amount of death benefit needed Duration of the need Client factors POLICY REPLACEMENT Chapter 4: Life Insurance45 FINANCIAL STABILITY CLIENT SERVICE REPUTATION FOR PAYING CLAIMS UNDERWRITING STANDARDS POLICY PRICING Chapter 4: Life Insurance46 Rating Agencies A.M. BEST Fitch Moodys Standard & Poors Weiss Chapter 4: Life Insurance47 Two Time-tested Methods: Human Value Approach Based on Clients Income Potential Capital Needs Analysis Sufficient for Covering Familys Economic needs Chapter 4: Life Insurance48 Chapter 4: Life Insurance49 Table 4-8 Family and Financial Data for John Smith Chapter 4: Life Insurance50 Payoff mortgage? Payoff debt? Pay for kids education? Pay for final death expenses? Monthly income to replace? Chapter 4: Life Insurance51 Chapter 4: Life Insurance52 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. Financial planning / life insurance needs 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 Insurance53