Lesson 2 of Insurance: Life, Health, and Disability Insurance Flashcards
Why Purchase Life Insurance!
- Income replacement in the event of the death of the family’s primary wage earner.
- Income for readjustment period after the death of a loved one.
- Financial support for dependents or elderly parents of the primary care giver.
- To fund children’s education after the death of the parent and/or guardian.
- Paying off debts such as a mortgage, car or other debts for surviving family.
- Providing income for the surviving spouse.
- The Cost of Insurance
- Age or Mortality Cost
The Cost of Insurance:
- Age on the x-axis and Premiums on the y-axis.
- As age increases, premiums increase.
Age or Mortality Cost:
- Age x-axis and Mortality Cost y-axis.
- As age increases, mortality costs increase.
Approaches to Providing Adequate Protection!
The Capital Needs Approach - List
- Income needs, education, retirement funding.
- A list of What Needs to happen:
- Mortgage
- Boat
- Vacation
- Education
The Human Life Value Approach
- Less amount of income earned, less consumed by insured.
Capital Retention
- Not invade the capital, but use it as an income generator.
- In 5 years or 10 years the balance is $5 Million. How much do I need to put in so 5 million is always there.
Income Retention
- Maintain income level.
- Assumption that when my wife dies in 30 years, there is nothing in acccount. On a inflation assumption.
Income Multiplier
- Multiple of income
- Example:
- 10x $50,000
- 10 x 50,000
Needs Approach
- Evaluates the income replacement and lump-sum needs of survivors in the event of an income producer’s untimely death.
- Any future cash or income need should be discounted using the present value of that future cash flows.
Most Common Needs Include
- Lump-sum cash needs
- Final expenses
- Debt Repayment
- Education expense needs
- Emergency Expenses needs
- Income needs
- Readjustment period needs
- Dependency period needs
- Spousal life income needs
- This includes a “blackout period,” which begins when social security survivor benefits cease (last child reaches age 16) and ends when the spouse begins receiving social security retirement benefits (age 60 at the earliest).
Human Life Value Approach
- Uses projected earnings less self-maintenance costs at the basis for measuring the life insurance needs.
- Figuring out PV
-
Important items in calculating the Human Life includes:
- Individual current earnings
- Future Growth Rate of earnings,
- Number of working years remaining
- Cost of self-maintenance
- and the capitalization rate (discount rate.) Less amount of income earned, less consumed by insured.
Human Life Value Approach Example
“Dave earns $45,000 after tax this year and his personal expenditures are $8,000 per year. He believes that his salary will grow at 4% per year, his heirs can earn 6% on any investments, and he will work for another 26 years. What is his human life value insurance need?
N =26
I = [1+.06) ÷ (1+.04))] - 1 x100 = 1.923%
PMT = $45,000 - 8,000 = $37,000
FV = 0
PV =??
Human Life Value Insurance (PV) = $751,482.34
Term Life Insurance
- Pure life insurance protection which pays a predetermined sum if the insured dies during a specified period of time.
- Protection ceases at the end of the term useless renewed.
- Premium pattern may be level or increasing on an annual or set period basis.
- Face amount may be level or decreasing.
- Maximum death benefit per premium dollar spent.
- Suitable for temporary needs, young families.
- There is no cash value, savings component or investment component.
- It is very inexpensive at young ages.
- Needs such as education funding paying off debts, or to cover expenses during the grieving process.
- This is the answer most of the time for young clients, especially with children.
Term Life Insurance - Provisions
- Renewable
- Convertible
- Waiver of Premium
Renewable
- Most term policies can be renewed without evidence of insurability.
Convertible
Most term policies have provisions to convert
- to a whole life policy
- without evidence of insurability
- for a particular period of time. (May be less than the full term).
Waiver of Premium
- If the insured becomes totally disabled,
- the premiums are waived during the period of disability.
Term Life Insurance - Limitations
- Exponentially increasing premiums for older age entry or renewal.
- Mortality cost of the premium increases each year.
- Most term policies are lapsed without collection by the insured.
- No savings component, cash value, or investment component.
- Term policies may not meet permanent insurance needs.
- Permanent needs would be if the insured required life insurance throughout her lifetime.
Term Life Policies!
- Annual Renewable Term (ART)
- Long Term
- Decreasing Term
Annual Renewable Term (ART)
- ART premiums increase annually.
- Every year the policy becomes more expensive.
- There’s no cash value associated with ART.
- Death benefits is fixed at the face amount of the policy.
Advantages of ART
- Pure death benefit protection that is inexpensive
- Insured receives a maximum death benefit for each dollar in premiums.
- ART can be converted to a permanent policy without proving insurability.
Disadvantages of ART
- ART may become too costly at older ages.
- There is no savings component
- Premiums increase each year.
Level Term
- Premiums are level for a period of time such that the insured prepays some of the later.
- More expensive premiums earlier in the policy.
- No cash value associated with a level of term policy.
- Death benefits is fixed at the face amount of the policy.
Advantages of Level Term
- Premiums remain level, which helps the insured budget a fixed amount each month.
- Results in lower premiums later in the policy.
- Level Term provides a pure death benefit protection that is inexpensive.
- The insured receives a maximum death benefit for each dollar in premiums.
- Can be converted to a permanent policy without proving insurability.
Disadvantages of Level
- The insured overpays premiums initially.
- There is no savings component.
Decreasing Term
- Premiums are level for a decreasing term policy.
- Take into account death benefit is declining.
- There’s no cash value associated with a decreasing term policy.
- Death benefit DECREASES over the term of the policy.
- Not very popular, but can be economically reasonable.
Appropriate Uses of Term Life Policies!
-
Only for temporary needs:
- such as education funding,
- paying off debt, or
- to cover expenses during the grieving process.
-
For decreasing term, the most appropriate use would be to
- payoff a mortgage.
Whole Life Insurance of Permanent Life Insurance!
- Whole life policies provide lifetime protection if premiums are paid as agreed.
- All whole-life policies pre-fund future higher mortality costs using present value analysis.
- Premium patterns may vary widely from a single premium to level premiums over a fixed term, or level premiums for life.
- Whole life policies have a savings or investment component with earnings accruing on the residual of the premium less the cost for the year plus any previous savings balance.
- ~ Premiums $2,000
- ~ Mortality Cost <$1,200>
- ~ Overhead Profit <$300>
- = Savings Component = $500
- Cash values may be used for loans or may be received if the policy is surrendered.
- The cash surrender value is the cash value less cash surrender charges.
- Cash values usually have a minimum guaranteed rate of interest.
- Participating or non-participating (DIVIDENDS - Included)
Exam Tip:
- If they describe someone who wants guarnatees or doesn’t want chance something to go sideways. Is conservative.
Advantages of Whole Life Insurance of Permanent Life Insurance
- Whole life policies provide tax-deferred growth of cash value.
- Whole life provides permanent protection until age 120.
Disadvantages of Whole Life Insurance of Permanent Life Insurance
- Premiums are expensive and there is no flexibility with the premium payments.
- Cash value grow gradually.
- Insured may not be able to purchase as much protection.
Types of Whole Life Insurance!
- Ordinary Life
- Limited Pay Life
- Variable Life
- Current Assumption Whole Life (CAWL)
Ordinary Life
- Insured pays premium until age 120 or death
- Cash value increases to face value at age 120.
- Death benefit is level throughout the term of the policy.
Limited Pay Life
- Premiums are higher than ordinary life
- because the insured only pays premiums until a certain age.
Variable Life
- Cash value is invested in stock, bond, and money market mutual funds. (subaccounts)
- An opportunity for higher returns on cash value exists with variable life.
- Death benefit and cash value fluctuate based on investment performance.
- Fixed Premiums
(INFLEXIBLE) PURPOSES ON EXAM NOT FLEXIBLE
Current Assumption Whole Life (CAWL)
- The insurer uses new money rates and new mortality rates to establish premiums.
- In the event that interest rates turn out to be too high and premiums too low,
- the insurer reserves the right to adjust the premium once,
- usually at the five-year mark.
Lo CAWL
- Is a low premium assuming a higher interest rate for crediting.
- Interest-sensitive insurance (Lo CAWL) is designed to create demand due to lower premiums.
Hi CAWL
- Assumes a lower interest rate that is currently being credited
- resulting in a higher premium with the possibility of a one-time downward adjustment at year five.
Whole Life Insurance CFP Exam Tip
The Blanket of Guarantees
- Guaranteed Premiums
- Guaranteed Death Benefit
- Guaranteed Cash Accumulation.
Appropriate Uses of Whole Life Insurance!
-
Anyone with lifetime and permanent needs.
- Income
- Retirement Funding
- Estate Tax
-
Estate planning purposes to provide liquidity to pay transfer taxes.
- Provide liquidity at death to pay taxes,
- provide income during the grieving process, or
- payoff debts.
- Insured has a need for investment like performance/returns.
- Suitable for income, retirement funding, and estate tax.
- Have a savings or investment component. .
Individual Life Insurance Policies!
Multiple Insureds
- First-to-Die
- Second or Last-to-Die
First to die
- Provides death benefits when the first insured dies.
- The first-to-die life expectancy is less than either single life expectancy.
- All else being equal this is the more expensive form of individual insurance.
Second or last to die (AKA Survivorship Life)
- provides death benefits when the second or last insured dies.
- Second to die life expectancy is greater than either individual life expectancy.
- Second-to-die policy is appropriate to pay for estate taxes and provide liquidity.
- This is the most common form.
Dividend Options!
- Nonparticipating
- Participating
- Dividend options
Nonparticipating
- Whole life policy does not pay dividends.
Participating
- Whole life participating policy will pay dividends.
Dividend Options
(Not reported on 1900-DIV statement)
(Not dividends reported on a 1900-DIV statement, are insurance dividends).
- Cash
- Accumulate at Interest
- Reduce Premiums
- Paid-up Additions
- One-Year term
Exam Tip:
- Remember that dividends are a CRAP-0
Cash
- Client receive money and can use it or invest as they wish
Accumulate at Interest
- The company invests the dividends and they are tax-free up to the client’s basis in the policy.
- Interest paid on the dividends is taxable.
Reduce Premiums
- Decrease the out-of-pocket expense for premiums.
Paid-up Additions
- Purchases additional insurance each year for insured regardless of health or occupation.
- Increase in Death Benefit
- Most Popular for Whole Life
- Once they do the paid up additions they remain on the policy.
One-year Term
- Adds term insurance each year to the policy face amount equal to the cash value of the policy.
Exam Tip:
- Also known as the 5th dividend option on the CFP EXAM.
Once they do the paid up additions they remain on the policy.
Settlement Options for Life Insurance!
- Lump Sum Payment
- Interest Only
-
Annuity Payments from Life Insurance
- Fixed Amount
- Life Income
- Fixed Period
- Life Income with Period Criteria
- Joint and Last Survivor Income
Lump Sum Payment
- Pay the lump sum directly in the form of a check to the beneficiary.
When someone dies, beneficiary will take it out as a lump sum. 99.9% of the time.
Interest Only
- Receive periodic payments of interest on the policy proceeds.
Annuity Payments from Life Insurance
- Fixed Amount
- Life Income
- Fixed Period
- Life Income with Period Criteria
- Joint and Last Survivor Income
Fixed Amount
- The beneficiary will receive fixed payments until the proceeds are depleted.
Life Income
- The life income option converts the death benefits into an annuity contract for the life of the beneficiary.
Fixed Period
- Instead of receiving an annuity payment over the lifetime of the beneficiary, the death benefit proceeds may be used to purchase an annuity certain, which is an annuity that will make payments for a specified number of periods (usually years).
- In financial planning engagements, using a fixed-period annuity payout may be preferential to the life income method when the beneficiary:
- Needs additional cash flow for a fixed period of time, such as until retirement age (when distributions from retirement accounts will begin).
- Suspects that he or she will have a shorter-than-average life expectancy and would like to preserve some of the death benefit value for a successor beneficiary if the primary beneficiary dies before the term expires.
Life Income with Period Criteria
- This method combines the benefits of the life income method with the benefits of the fixed-price method.
- This approach transforms the death benefit into a life annuity contract based on the age and health of the beneficiary, yet promises to make a specified number of payments under the contract.
Joint and Last Survivor Income
- With a joint and last survivor income settlement option, annuity payments are made over the joint lives of two individuals.
- When one of the joint annuitants dies, the survivor will receive a reduced payment for the rest of his or her life.
Life Insurance Nonforfeiture Options!
- After the policy develops a nonforfeiture value, the policy may be surrendered and the surrender value may be.
- Taken in cash
- Used as a single premium to purchase a paid-up life insurance policy.
- Used to buy extended-term insurance.
-
Subtopics:
- Cash surrender value
- Reduced paid-up insurance
- Extended Term Insurance
- Accelerated Death Benefits
Cash Surrender Value
- Insured receives the accumulated cash value when terminating the life insurance policy.
- The cash surrender value is the cash value less surrender charges.
Reduced Paid-up Insurance
- Insured receives the cash value in the form of a paid-up policy with a smaller face amount.
Extended Term Insurance
- The insured receives the cash value in the form of a paid-up term policy for a specific duration, with the same face amount as the original policy.
Accelerated Death Benefits
- If an insured becomes terminally ill, the insured may take an accelerated death benefit.
- Accelerated death benefits may be in the form of a lump sum or monthly income.
- Any payments are deducted from the policy’s face value.
- Life expectancy must be 24 months or less.
- Income from an accelerated death benefit is not taxable to the insured.
- There are no restrictions on what the accelerated death benefit can be used for:
- Medical care,
- home health care,
- nursing home,
- trip around the world, or
- a new car.
Universal Life Insurance!
- Is a Permanent Policy
-
Types of Universal Life Insurance
- Universal Life A (Universal Life Option 1)
- Universal Life A (Universal Life Option 2)
- Non Direct Recognition Program
- Direct Recognition Program
-
Insured may adjust: (FLEXIBILITY)
- Premiums paid,
- face value of the policy, and
- cash value.
- Insured does not direct the investment portion of the cash value.
- Cash value can be used to actually pay the policy premiums.
- NAR = Net Amount at Risk
- Is Unbundled
EXAMPLE:
- Bill pays his premium of $1,500 which is added to the cash value of his policy of $10,000. His new cash value is $11,500. The insurance company then reduces his cash value to reflect the portion of his premium to cover the mortality costs, administrative expenses, and insurer profit. This portion of the premium is $1,000, so the ending cash value is $10,500.
- If Bill preferred he could just use the original cash value of $10,000 to pay his entire premium.
UNIVERSAL LIFE FLEXIBLE
HAS 0 GUARANTEES
Universal Life A (Universal Life Option 1)
- A flexible premium, adjustable death benefit, and unbundled (profit, cash) life insurance contract.
- If the cash value gets high enough, the death benefit will increase.
- Normally, the amount of insurance purchased declines as the cash value rises, keeping the total death benefit level.
- The beneficiary receives the cash value or death benefit.
- Cheaper Option Between A and B.
EXAMPLE:
- Tiffany purchases a universal life insurance policy with a face amount of $1,000,000 and a cash value of $100,000. Death Benefit would be $1M.
Universal Life B (Universal Life Option 2)
- Same as Universal A except that death benefits vary directly with the cash values.
- Universal B is more expensive than Universal A because the death benefit is equal to a specified amount of insurance plus the cash value, and the total death benefit will typically rise.
- The beneficiary receives the cash value or death benefit.
- More expensive option.
EXAMPLE:
- Tiffany purchases a universal life insurance policy with a face amount of $1,000,000 and a cash value of $100,000. The death benefit would be $1,100,000.
Variable Universal Life
-
A product with investment options such as
- stock,
- bond, and
- money market mutual funds.
- There is no minimum guaranteed rate of return or interest.
- Cash value is invested in a separate account, not the insurer’s general account.
- Insured direct investments of the cash value into stock, bond, and MM mutual funds. Has to be allowed from insurance company.
- Cash value is not guaranteed but in the event of an insurance company failure, the separate account will be treated as an asset of the insurance company.
- Variable Premiums
All Same Flexibility as Universal Life but more FLEXIBILITY.
Variable is Sub Accounts.
Individual gets to Choose with Investment Options.
More Risk but they can get more return.
Advantages + Disadvantages of Universal Life Insurance
Advantages:
- The policy owner determines the frequency and amount of each premium.
- The death benefit may increase.
Disadvantages:
- The death benefit may decrease.
Non-Direct Recognition Program
A non-direct recognition approach
- does not adjust the dividends paid on a policy
- where there is an outstanding loan against the cash value of a policy.
Direct Recognition Program
The direct recognition approach, dividends are reduced by any outstanding loan against the policy.
Feature Comparison of Common Life Insurance Policies
- The Use part is most important for the exam.
Cash Value can be replaced with investments.
Termination Options (Slides)
Also on a previous slide.
Example to use:
- Policy is for $100,000
- Cash Value $30,000
- Whole Life Policy
- Paying $1,000 do not want to pay anymore.
After the policy develops a nonforfeiture value, the policy may be surrendered and the surrender value may be
- Taken in cash
-
Used as a single premium to purchase a paid-up life insurance policy.
- Reduced Paid Up Quote: $60,000 is Death Benefit.
- No More Premiums paid is advantage.
-
Used to buy extended term insurance.
- Give extended Term 16 Years.
- Death Benefit stays at $100,000
- If I die in 15 Years my wife gets $100,000
- If I die in 16 years and 1 week my wife gets nothing
Business Use of Insurance (Slides)
Buy Sell Agreements Funded With Life Insurance
Cross Purchase:
- Pros:
- Increase in surviving partner’s basis
- Cons:
- Lots of policies = N * (N-1)
- N is owners
- Cost Variances
- Study Tips:
- Recommended for 2-3 owners.
Entity Purchase:
- Pros:
- Company Pays
- Much fewer policies needed
- Cons:
- Does NOT increase surviving partner’s basis.
- Study Tips:
- Recommended for 8-9 owners.
Key Person Insurance
- Designed to protect a business upon the loss of key employee
- Premiums are not a deductible business expense
- Death proceeds are received tax-free
Life Insurance Policy Provisions!
- Grace Period
- Misstatement of Gender or Age
- Suicide
- Disability Waiver of Premium
- Incontestability
Grace Period
- Typically lasts 31-61 days after the premium due date in which policy remains in force.
- If insured dies during grace period, the insurer assumes the insured would have renewed.
- The insurer will pay the death benefit and deduct the premium.
Misstatement of Gender or Age
- Younger persons and women pay less for life insurance
- Misstatement of age on an application will not void the contract
- The death benefit will be paid, but reduced by what premiums would have been if age was accurately stated.
Incontestability
- States that once the policy has been in force for a period of time (typically two years),
- the insurer may not cancel the policy if they later discover a material misrepresentation omission or concealment.
EXAM QUESTION Misstatement of Gender or Age
Cindy, who is actually 45, has been lying about her age for the last 15-20 years and tells Connor, the insurance agent, that she is 30. She has a driver’s license to support age of 30. She buys a $1M term life policy paying premiums of $1 per thousand. Age 45 premiums are $2.50 per thousand. Cindy dies in the first year. Which is correct?
a) Beneficiaries collect $0 but get the premiums back because Cindy died.
b) Beneficiaries collect $1M as long as her death was accidental.
c) Beneficiaries collect $40,000, which is the policy value with premiums adjusted for actual age.
d) The policy is voidable for up to two years by the insurance company for fraud.
Answer: C
The face is adjusted for the correct premiums. Cindy is paying (1,0000,000 ÷1,000) x 1.
She should be paying 2.50 per 1,000, so the face is adjusted to $400,000.
(1,000÷2.50) x 1,000 = 400,000.
Suicide
- Coverage is excluded if suicide is committed within one or two years of purchasing the policy.
- If suicide is committed within the exclusion period, premiums are returned.
Disability Waiver of Provisions
Whole Life:
- The insurer will waive all premiums after disability
Universal and Variable Universal:
- Insurer will waive the charges related to mortality and administration OR waive the entire premium.
Assignment!
The policy owner assigns rights to life insurance contract to someone else.
- Absolute Assignment
- Collateral Assignment
Absolute Assignment
- The owners transfer all policy ownership rights, typically the result of divorce.
Collateral Assignments
- Collateral assignments are used for collateral on debt, which only assigns limited ownership rights.
- The assignment automatically terminates when the debt is satisfied.
- Most participating whole-life policies use DIRECT RECOGNITION, which reduces dividends and interest for the portion of the cash value used as collateral for loans.
Group Life Insurance!
- Group Term Insurance
- Group Whole Life Insurance
Group Term Insurance
- Group term is the most common form of insurance offered by employers.
- Premiums for the first $50,000 in coverage are tax-free.
- Premiums paid by employers are tax deductibles.
- Premiums paid by the employee are with after-tax dollars.
- Income must be imputed based on the coverage in excess of $50,000.