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Chapter 13

Buying Life Insurance

Agenda2

Determining the Cost of Life Insurance

Rate of Return on Saving Component

Taxation of Life Insurance

Shopping for Life Insurance

Determining the Cost of Life Insurance3

The cost of a life insurance policy is the difference between what you pay and what you get back

When determining the cost of life insurance, four major factors must be considered:

1. Annual premiums

2. Cash values

3. Dividends

4. Time value of money

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Determining the Cost of Life Insurance4

Under the traditional net cost method, the cash value and expected dividends are subtracted from annual premiums to obtain a net cost per year figure This method does not consider the time value of money

Traditional Net Cost Method 5

Determining the Cost of Life Insurance6

The interest-adjusted cost method is more accurate because it considers the time value of money

Two interest-adjusted cost indices: The surrender cost index is useful if the owner expects

to surrender the policy after some time period The net payment cost index is useful if the owner

expects to keep the policy in force

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Surrender Cost Index 7

Surrender Cost Index8

Net Premiums: Compute the FVA of the premiums

Subtract the FV of the dividends

Subtract the Cash Value (@ 20 yrs)

Apply the discount factor Divide Net Premium by FVAD of $1 FVAD = [(1+r)/r][(1+r)T – 1]

Divide by Coverage

Net Payment Cost Index 9

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Net Payment Cost Index10

Net Premiums: Compute the FVA of the premiums

Subtract the FV of the dividends

Apply the discount factor Divide Net Premium by FVAD of $1 FVAD = [(1+r)/r][(1+r)T – 1]

Divide by Coverage

Determining the Cost of Life Insurance11

Interest-adjusted cost indices can be used to compare policies across insurers There is a wide variation in costs indices across

insurers – it pays to shop around!

Most consumers use premiums as a basis for comparison, but agents will supply cost indices

Comparison of Interest-Adjusted Costs for Selected Companies

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Determining the Cost of Life Insurance13

The Life Insurance Policy Illustration Model Act requires insurers to present certain information to applicants for life insurance The goal is to reduce misunderstanding of policy values by

policyowners, and reduce deceptive sales practices by agents A narrative summary describes the basic characteristics of the policy A numeric summary shows the premium outlay, value of the accumulation

account, cash surrender values and death benefit The act also prohibits certain sales practices and requires the insurer to

provide an annual report

Rate of Return on Saving Component14

The annual rate of return earned on the savings component of a policy is an important consideration if you intend to invest over a long period of time

The Linton yield is the average annual rate of return on a cash value policy if it is held for a specified number of years Current information is not readily available to

consumers, so the method has limited use

Average Annual Rates of Return for 109 Cash-Value Policies by Year of Policy

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Rate of Return on Saving Component

The yearly rate of return method is based on a formula:

The information needed for the calculation is readily available to consumers

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Benchmark Prices17

Taxation of Life Insurance18

Life insurance proceeds paid in a lump sum to a designated beneficiary are generally received income-tax free The interest component of periodic payments is taxable as

ordinary income

Premiums are generally not deductible

Dividends are not taxable, but interest on dividends retained is taxable

If a policy is surrendered for its cash value, any gain is taxable as ordinary income

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Taxation of Life Insurance19

Proceeds from a life insurance policy are included in the gross estate of the insured for federal estate-tax purposes if: the insured has any ownership interest they are payable to the estate

The proceeds may be removed from the gross estate if the policyowner makes an absolute assignment of the policy to someone else The policyowner must make the assignment more than three years

before death

Taxation of Life Insurance20

A federal estate tax is payable if the decedent's taxable estate exceeds certain limits A tentative tax on the taxable estate value is calculated

The gross estate includes property you own, one-half of the value of property owned jointly with your spouse, life insurance death proceeds in which you have ownership interest

The gross estate may be reduced by certain deductions, such as a marital deduction, in determining the taxable estate

The taxable estate may be reduced or eliminated by a tax credit called a unified credit

The amount of property exempt from taxation will increase in the future

Federal estate taxes are scheduled to expire in 2010 Tax will be reinstated in 2011 unless Congress acts

Calculating Federal Estate Taxes*

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Calculating Federal Estate Taxes*

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Calculating Federal Estate Taxes23

Individual dies in 2010 No estate tax

Basis for future tax changed

Individual dies on 2011, 2012 $5M exemption, 35% tax rate 99.5% of estates are expemt

Individual dies on 2013+ $1M exemption, 55% tax rate

Shopping For Life Insurance24

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Rating Categories for Major Rating Agencies25

Calculation of Life Insurance Premiums

Chapter 13Appendix

Premium Calculations in Life Insurance27

The net single premium (NSP) is defined as the present value of the future death benefit

The NSP is based on three assumptions: Premiums are paid at the beginning of the policy year

Death claims are paid at the end of the policy year

The death rate is uniform throughout the year

This is just an Expected Present Value calc.

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Calculating the Net Single Premium for Term Insurance

For yearly renewable term insurance, the cost of each year’s insurance is easily determined:

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Commissioners 2001 Standard Ordinary (CSO) Table of Mortality, Male Lives (selected ages)

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Present Value of $1 at 5.5% compound interest30

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Calculating the Net Single Premium for Term Insurance31

For a five-year term policy, the cost of each year’s mortality must be computed separately for each of the five years and then added together to determine the NSP

Calculating the NSP for a Five-Year Term Insurance Policy, Male, Age 32

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Calculating the Net Single Premium for Ordinary Life 33

For an ordinary life insurance policy, the cost of each year’s mortality must be computed separately for each year to the end of the mortality table, and then added together to determine the NSP

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Calculating the Net Annual Level Premium

The net annual level premium is calculated using a formula:

If premiums are paid for life, the premium is called a whole life annuity due

If premiums are paid for only a temporary period, the premium is called a temporary life annuity due

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Policy Reserves35

Under the level-premium method for paying premiums, premiums paid during early years are higher than necessary to pay death claims The excess premiums are reflected in the policy reserve

Policy reserves are a liability item on the insurer’s balance sheet that must be offset by assets equal to that amount

The policy reserve is the difference between the PV of future benefits and the PV of future net premiums

The policy reserve has two purposes: It is a formal recognition of the insurer’s obligation to pay future claims

It is a legal test of the insurer’s solvency

Prospective Reserve — Ordinary Life Insurance(1980 CSO mortality table)

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Policy Reserves37

The retrospective reserve represents the net premiums collected by the insurer for a particular block of policies, plus interest earnings at an assumed rate, less the amounts paid out as death claims

The prospective reserve is the difference between the present value of future benefits and the present value of future net premiums

Both methods will produce the same level of reserves at the end of any given year under the same actuarial assumptions

Policy Reserves38

A terminal reserve is the reserve at the end of any given policy year

The initial reserve is the reserve at the beginning of any policy year

The mean reserve is the average of the terminal and initial reserves. It is used to indicate the insurer’s reserve liabilities on its annual statement

Case Application39