fin512 chapter 8 - life insurance

7/21/2019 FIN512 Chapter 8 - Life Insurance

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Chapter 8 – Life Insurance

Introduction

- The purpose of insurance is to finance the risk of a financial loss- Primary purpose for life insurance is to finance the risk of the premature and untimely death of a

family member whom others are financially dependent, the goal being to avoid financial deprivationfor these dependents

- Fundamental objective of life insurance is to provide enough money to finance future needs. Ie.Day-to-day living expenses and education costs for children, not to provide a windfall for thebeneficiary or beneficiaries

- There are three questions to be addressed before buying life insurance:

. o you need life insurance! ! The insupportable risk is the loss of income. People need lifeinsurance only if their dependents would suffer financially ! they would experience amaterial drop in their standard of living

". "o# much life insurance do you need! – # ways of assessing this$a% Income Approach ! calculates P& of insured's future a-tax earnings. (lso called the

human life value approach

b% Expense Approach ! looks at various family needs, taking into account special

needs. Ie. future education of children, o)s mortgage * retirement needs and ad+ustingthis amount for present assets that can meet some of the financial needs. (lso calledthe needs approach

c% Capital Retention Approach ! much like expense approach except that the insuranceproceeds are invested and only the income is used to meet reuired financial needs.Proceeds are then preserved to be distributed later to the heirs.

$% &hat 'ind of insurance should insured buy! (Term or &hole Life)

a% Temporary life insurance (Term) ! provides insurance coverage for a specific periodof time

b% Permanent life insurance (Whole Life) – provides insurance for one's lifetime * thepremium usually includes a savings portion. everal types$

i. Term*to*+,, ! doesn't have a savings component. ometimes, if insured lives to, the face value is paid out even if insured is still aliveii. /hole life policies have a savins component called cash surrender value

iii. -niversal life policies – similar to whole life, but have flexibility as their mainfeature ! +ust about everything in policy can be changed including premium *term. This is self-directed insurance where policyholder selects premium, term,investments * several other items

o you need life insurance!

./:

- 0ingle people #ith no assets that will be taxed at death usually don't need it. The principal residenceis e1empt from capital gains ta1 0not taxed%, and financial assets 0stock portfolio can be partiallyliuidated to pay final taxes%

- 0pousal rollover permits registered assets ! 11Ps, 1PPs to be rolled over to surviving spouse withno tax conseuences

230: 0life insurance can be an invaluable risk mngmt or savings tool%- 4rovide for financially dependent family should you die prematurely – both parents work and have

young children ! if one dies, the other would not be able to maintain his or her standard of living w)oincome of deceased. They can manage risk by calc. appropriate amount of insurance coverage *buying life insurance



- Insurance to pay the ta1es on your estate – insurance for estate pays taxes at death. In 2anada, adeceased's estate can be rolled over ! title changes hands w)o paying taxes to deceased's spouse !called spousal rollover. 3owever, taxes will become due on some assets when " nd spouse dies.o 31% there might be a family cottage that current owners would like to pass on to their heirs. 4ife

insurance payable on death of "nd spouse can be used to pay income taxes on capital gain 0whichcould be considerable given recent increase in value of cottages%. 2apital gain is huge when itpasses on to children ! 56 is taxed at your marginal rate, but if your parents buy whole life

insurance ! it will pay out amount that they will have to pay out for taxes on estate- Finance a buy*out by business partners if + partner dies prematurely – partners in a business often

have a buy-sell agreement that permits remaining partner0s% to buy share0s% of deceased partner0s%.They may have an agreement as to the price or they might have established a formula for determiningvalue of deceased's share. The survivor0s% could finance a buy-out w. a sinking fund or by getting abank loan, but both options would tie up working capital, which most small businesses can't readilyafford. Instead, partner0s% or business can buy life insurance on each partner. Premiums can be paid by$

+% Partners in proportion to their ownership although this doesn't manage varying cost of insuringeach partner, which depends on his or her health * age

5% Partnership or corporation w. beneficiaries of each policy being either$a. 7ther partner, who then has funds for purchase of deceased's share

b. 2orporation, which can buy back shares * distribute them or retire them- 6 ta1*advantaged #ay of saving for retirement - a whole life policy can be set up to buy additionalinsurance benefits out of dividends on participating polices, and the savings component of thesepolicies can be accessed w)o terminating the policy

o TF06 allows a person 8yrs9 to save :5, a year * the income is never taxed. 7ne can

borrow from a T;( and repay loan w)o using new contribution room.o 7704s also grow tax-free, contributions are tax-deductible, and all withdrawals are taxed at a

person's highest tax rate. There could be a good reason to save using a life insurance policy,which also grows before tax.

"o# much life insurance do you need!

- (ll make assumptions about the future, but since there's no way to know the future, an educated guessis better than picking a random number

- (ll approaches base future need in real dollars – dollars w)o inflation. o we discount future income ata real interest rate of #6, which means inflation doesn't have to be added to their salaries to do thiscalc. The real interest rate, which contains no inflation or ad+ustments for risk is between "-<6

- # different methods, # different answers

+% Income or "uman Life alue 6pproach – person's ability to earn income is their greatest asset, thisis a simple, uick way to estimate amount of insurance to buy- Take P& of current a-tax income, discounted at some real interest rate

o /hat's your earning potential over the next x years and bring it to P& using real rate of

interest. 4ayments happen at 93 of year% => yrs, I > #6, P& > ?, P@T > salary, ;&>o 2alc. P& of lost earnings over the term of the insurance.

- It doesn't' take into account any special needs * is based on assumption that present income levelswill be adeuate for future needs.

- The time the insurance is needed can be fairly short ! until the children are through schoolA mid-term, until surviving partner retiresA or long-term, until surviving partner dies

5% 31pense or .eeds 6pproach ! attempts to predict future expenses that couldn't be financed out of



current levels of income * make an allowance for them. These needs might include the mortgage, finale1penses: funeral expenses, a liuidity fund to cover retirement * estate planning needs, theirchildren's education, in additional to income replacement * support for their dependents.- (pproach involves looking at$

o (ssets available to produce income minus what they owe if spouse dies to arrive at the

available capital

o 3ow much a-tax income the surviving spouse would have coming in each year and what the

annual expenses would be to arrive at the annual shortfallo The P& of the annual shortfall at the real interest rate for the reuired B of years

o The insurance needed by deducting the available capital from the P& of the shortfall

- 2alc. P& of shortfall between income and expenses over the term of the insurance.

- ;; Loo' at 31% 5 – 4g% 5<=*58+ more complicated than class example o If both parents die and children survive and are still minors 0under age 8)C%, insurance

proceeds would be put in a trust and their wills would stipulate who would be the trustee of thetrust and who would be the guardians for their children

o 2PP pays a survivor benefit and a children's benefit, both paid to surviving parent 0both are

taxable at marginal tax rate% ! amount depends on how much deceased has contributed.o @ay have to include mortgage of house in liabilities if you don't have mortgage life

insurance> which would pay off the mortgage in event of either of them dyingo 2an include 11P, but not cash value of 1PP through their +obs b)c money is not available to

consumer before retirement contributory plans ! ie. you pay 6 and employer pays 6 ofgross salary towards pension plan, so you are saving "6 of gross pay each year towardretirement.

$% Capital 7etention 6pproach ! assumes that the survivor wishes to preserve the capital and live of thea-tax income generated by investing the insurance proceeds. It involves looking at the annual shortfallfrom the expense approach and dividing it by some expected real rate of return 0alternatively, you couldbase it on the income approach and use their a-tax income instead of the annual shortfall%. Then deductthe amount of available capital to arrive at the amount of insurance needed to provide for the familyw)o using the capital- 2alc. the amount of insurance needs to fund needs in perpetuity – capital that will produce income

forever 0no loss of capital%.

- ;; 31% $ – pg% 58+*585 takes a look at thisEo Take the annual shortfall and divide it by the expected real rate of return of #6 to find out how

much insurance they would need to have to over the shortfall w)o using up the capital. Theyare setting up a perpetuity ! capital that will produce income forever

o Foanne dies, Don has$ shortfall G7H 0<,##% ) k 0#6% > P&( 0,5,% minus available

capital 0-5",5% insurance needed > :,5"<,o If they want to have enough capital that the survivor could live off the income, preserving the

capital, the capitali?ed value of the annual shortfall indicates Foanne needs to have close to:C, of insurance. 03ow do you get this number?%



!ummary of " approaches#+% Income approach

- Jasiest, but doesn't take into account any extra expenses that might be incurred. 0Doesn'taccount for changes in expenses after death of spouse%

5% 31pense 6pproach

- @ost appropriate as it replaces current income and also ad+usts for assets that can productincome as well as for future possible expenses

- @ost accurate, but reuires calculation of assets and expenses$% Capital 7etention 6pproach

- /ould be favoured by people selling insurance, but is it really necessary to buy insurance toprovide an inheritance for one's children? It's like overkill unless of the children needs to besupported for his)her entire life.

- Incorporates beuests 0inheritances%

- Perpetuity may lead to over-insurance- This analysis is usually repeated every 5 years or so, and also if there were a significant change in

fortunes like winning the lottery or inheriting a small fortune, or if there's a divorce or semi-permanent +ob loss or a permanent disability or a desire to change careers, all of which can lead to a change ininsurance needs

0ettlement options – Collecting the Insurance

- If at some point the insured dies, the beneficiary can elect to take the face value 0the proceeds% in #different ways$

. Lump sum payment – receives full amount, and it's not ta1able% /hen you invest the money toearn annual income, the annual income is taxable

". Interest option – Proceeds 0principal% stay with insurer and interest is paid periodically to thebeneficiary as ta1able income% 7nly interest is paid out Interest is taxable. 0This is the 2apital1etention option%

#. Annuity ! pay me x amount every month for the next x amount of years- Interest portion is ta1able. 4rincipal returned is non*ta1able%

- 4rescribed annuity amortiKes taxes over life of annuity so that tax is leveled across theannuity- Temporary Insurance

- ;irst year none is taxable b)c all of it is being returned to you ! it didn't get to build interest. =ext yearyou are taking your payment with the principal and some interest

- 31% @ – pg% 585*58$

• Don takes an annuity over 5 years. (lso elects to take payments annually at G7H 0inreality, would take payments monthly%. Insurer pays him a 6 nominal rate of return% =ominalreturn is used b)c taxes are applied to actual dollars, not their earning power 0which is reflected inreal dollars%

• LL 6morti?ation of annuity – Table 8%@ – 6*ta1 Income from an annuity ! know

how to do this for at least # linesEE LL• In the first year, payment is taken out of the :k at G7H and interest is earned onthe balance for the rest of the year. Don will receive :55,5".< per year 0n>5, I>5, P&>k,Pmt >?%

• Interest A 'B balance 9/2 1 interest rate• 4rinciple total (pmt) – interest A'B• 9alance3/2 balance 9/2 – principle

• Ta1 A 1B interest A'B 1 ta1 rate• 4ayment a*ta1 payment 6*ta1 yr + – ta1 A1B

• The table shows the amortiKation of a regular annuity – the interest portion if



taxable each year• This is a non*registered annuity since it wasn't bought with registered savings ! a

pension plan, a locked in 11P, a registered retirement income fund 011I;%, or a locked-in retirementaccount 04I1(%

• o Don can elect to treat the annuity as a prescribed annuity – meaning the total taxis amortiKed evenly over a max of 5 years ! the tax is the same every year, which reduces his overalltax bill.

- To qualify as a prescribed annuity the follo#ing must occur:• Payment must be made the same 0level, not indexed% each year but may be reduced on the st death

under a joint D last survivor annuity

• The +oint annuitant can be only the primary annuitant's spouse, brother)sister for a +oint *last survivor annuity

• The payee 0annuitant) must be the owner * an individual 0and may be a spouse, trust ortestamentary trust%, but not a corporation or a partnership

• 2an't be commuted or surrendered 0cash-in for a lump sum%• The annuity must be making payments since prescribed status can't apply during a deferred period• The guaranteed or term*certain period can't extend beyond the owner's Cst birthday 0or +oint

annuitant's Cst

birthday, if later%

- (nnuities have " fundamental determinants$. The time when payment begins$

a. Immediate annuities – begin paying right awayb. eferred annuity payments – don't begin until some time in the future

". The nature of insurer's obligation$a. Life annuities ! provide income for life and stop when the annuitant diesb. Life annuities #ith guaranteed E of payments ! pay for a fixed period of time they also

pay for life, but will continue the payouts to a beneficiary for the guaranteed B of years ifannuitant dies before guaranteed is reached

c. oint D last survivor annuities ! pay until the last annuitant diesd. Inde1ed annuity ! annuity that increases by some predetermined 6 or by 2PI each yeare. Installment refund annuities ! pay for life to the annuitant or a beneficiary until the

payment euals the purchase pricef. Cash refund annuities ! pay the balance to the beneficiary in a lump sum when the

annuitant diesg. ariable annuities ! pay an amount that varies each month according to the return on

investment for the prior year. There are many variations on these types of annuities

;; &ill be tested ;; - iff #ays term insurance can pay out: o 2an have single insurance,

o

2an have joint*life insurance

" people - you and spouse,o oint*and*last survivor pays out when "nd person dies, and,

o 2an have term*certain pays out guaranteed number of periods ! if last survivor dies before the

payments are done, it will be paid to the estate!ereate$ %un$s Intro- ( segregated fund is an individual variable insurance contract% It's a pool of money held in trust by

an insurance co., and the policyholder is the annuitant. (s a result, while it's an annuity, it's an annuitythat's payable only after the death of the policyholder or at the maturity of the segregated fund policy

- The maturity date of a segregated fund is some predetermined B of years, when the fund guarantees acertain value such as 56 and is set up at the inception of the policy. 3owever, if all or part of the



policy is terminated early, the maturity benefits aren't guaranteed- ince universal policies are the only form of insurance policies that can invest in segregated funds

0although segregated funds can also be purchased w)o using a universal life policy%, they will bediscussed after universal life insurance policies

Life Insurance 4olicies – Common 3lements

- (ll life insurance policies share some ualities$

o The life insured is person whose life is insuredo The age of the insured is the age of the life insured at the GJM of the policy year based on the

nearest or last birthday. The cost of the insurance at the inception of the policy and at anyrenewals depends on the insured's age

o ( dependent of the principal life insured is the spouse or child of the insured

o ( joint life insurance policy covers " or more lives. It pays out on the death of the st to die, at

which point the policy terminateso ( last*to*die policy covers " or more lives * pays on the death of the last to die

o ( second*to*die policy covers two lives and pays on the death of the "nd to die

o ( premium ta1 is the provincial tax on insurance policies. Menerally about "6

o 4ife insurance policies are creditor*proof ! creditors don't have access to the insurance proceeds

when insured dies, and insurer pays out the death benefit. 2reditors have access to proceeds onlyif$

Proceeds are paid to the estate

( beneficiary isn't the spouse, child, grandchild or parent, or

Policy is used as collateral on loan ! policy has been pledged as security for repayment ofloan, in which case it has been assigned to a #rd party

o The grace period is the time after a premium is due and is unpaid, but the policy * all riders

remain in force, that is, the policy is not cancelled for late payment during the grace period, whichis usually # days. If premium is paid during grace period, payment is considered to have beenpaid on time. If insured dies during grace period with premium not paid, the o)s premium isdeducted from the face value

o Gisstatement of age – has the same effect as for disability ! the face value will be ad+usted to

reflect the correct ageo ( life insurance trust is a testamentary trust set up with insurance proceeds

Ri$ers or &ptional Coverae- Typical riders that can be bought for all types of life insurance, usually when policy is taken out include$

o (n accelerated death benefit rider or livings benefits rifer ! allows insureds whoa re terminally ill

or who suffer from certain catastrophic diseases to collect all or part of their life insurance benefitsbefore they die. The benefits might be to pay for the medical care they reuired or living expenses ifthere's no disability insurance or not enough to cover additional expenses such as private nursing

caseo Child life insurance is a rider that provides insurance on the life of a child ! a child of 5 days is

automatically insured. uvenile insurance is insurance on childreno uaranteed insurable ! insured can increase coverage w)o proof of insurability. The additional

insurance is available at each option date as outlined in the policy. It can be useful when ma+or lifeevents take place such as marriage * the birth or legal adoption of a child

o ( #aiver of premium on disability rider waives the premium while the insured is disabled



'eneficiaries- ( beneficiary is the person0s%, corporation, trust or charity who receives the death benefit> the proceeds

of a life insurance contract.- ( named beneficiary is a person0s%, company, charity or the estate- 9eneficiary designation ! the beneficiary is designated or named in the insurance contract. If there's no

beneficiary named, the proceeds are paid to the insured's estate. /ith a designated beneficiary that's not the estate, there's no probate fee and no probate process ! the proceeds are paid directly to thebeneficiary w)o Ngoing through the estateO. (s a resuly, the benefit it paid out uickly * w)o payingprobate feeds. Geneficiary designation can't be contested

- 2ategories of beneficiaries$o ( primary beneficiary – the beneficiary who's entitled to receive the proceeds st when insured

die, while a contingent beneficiary receives proceeds only if primary beneficiary dies eitherbefore insured or before term of guaranteed term annuity has been paid out

o ( revocable beneficiary – can be changed after being named w)o beneficiary's consent !

revocable beneficiary has no enforceable rights even if s)he pays premium. (n irrevocablebeneficiary can't be changed once named except with the permission of the beneficiary ! insured

needs the consent of beneficiary in order to make changes to policy, including surrendering thepolicy for cash 0cashing in the policy%, changing the beneficiary, decreasing the coverage, orassigning the policy as collateral for a bank loan

o ( specific beneficiary is named, ex. Nmy children, @ike and 3illsO while a class of beneficiaries

is not named, ex. Nmy childrenO. This is impt if the executor has to decide whether or not NmychildrenO includes step-children, adopted children * children born out of wedlock

uarantee$Issue Policies- uaranteed*issue policies are brought through the mail or from a T& ad. They will usually advertise$

o =o health uestions and no medical exam

o (vailable even if other companies declined you

o 2an't be turned down ! all occupations * health histories are acceptableo ;ixed premium

o Muaranteed benefit never decreases with age, and

o (ges <- or 8

- These policies are usually very expensive since the applicant can't get insurance anywhere else.- @any plans don't actually guarantee approval since there are usually basic health uestions to help

insurance co. eliminate really high-risk applicants- The coverage is usually limited between :5k - :5k of coverage perhaps with an accidental death and

dismemberment rider or double indemnity rider that pays double the face value if insured dies from anaccident instead of from illness

- This rider is contrary to the analysis of the amount of life insurance reuired since amount of insurance

reuired doesn't double if insured dies from an accident- ome guaranteed-issue policies pay the full amount of the death benefit only if insured dies in an

accident. eath benefits are often graded ! if the insured person dies within a specified amount of time,usually " years, the beneficiaries receive only a portion of the death benefits



Types of Insurance: " types ! term insurance * whole life insurance

+% Temporary Insurance – Term Insurance

- Temporary insurance provides insurance coverage for a specified time period or term, and the onlytype of temporary insurance is term insurance

- It is pure insurance with no savings component - Insurer promises to pay a specific amount if insured dies within a specified period 0The term of thepolicy%. (t the end of the term, if insured is still alive, policy terminates and protection stops.

- 2ost of premium for term insurance includes only$o The pure premium> the cost to insure the person. The pure cost of insurance or mortality cost

is the probability of dying times the face value of the policyo Jxpenses such as marketing, selling and admin

o Profit

- Types of Term Insurance#o Term can be , 5, , 5 or " years

o Premium is usually level during the term

Level premium – remains the same over the life of the policy, but increases if policy isrenewed since the insured is older

ecreasing premium – coverage decreases as the expiry approaches. This is useful formortgages where insurance covers a decreasing liability

o Term of a term policy can vary$

Level term – coverage is the same throughout the life of the policy

ecreasing term – a policy in which the face value 0death benefit% decreases over time, butpremiums are level throughout the term

Premium shrinks over time so that if you die, at the very GJM of the policy, you will getlarge amount of money, but the longer the policy is in place, the less you will get.

Decreasing term is like @ortgage insurance ! pays off balance of your mortgage if youdie. The longer you live, you have paid off most of your mortgage.

Term to age H 0or term to 0kind of life whole life insurance% ! has level premiums and isusually convertible to a whole life before it expires

o 31tended term or paid*up term ! term policy bought by using the cash surrender value 02&% of a

whole life policy as a lump sum payment on a term insurance policy

- Term policies can be tailored to the individual's needs including providing coverage to age 5 or ,although it becomes expensive in later years. Term policies are useful if$ funds are limited, and)or theneed for protection is temporary

Ri$ers on Term Policies 0clauses)features you can buy on insurance to enhance it ! increases premium%o 7ene#able and Convertible (to #hole life)

o uaranteed convertible – has a conversion clause giving the policy owner the option to covert it

to a cash value policy such as whole life w)o evidence of insurability. (t conversion, the premium isbased on either the$• 6ttained*age method – age at conversion, or• /riginal*age method ! age when policy is taken out

- 2onvert term insurance to whole life w)o providing proof of insuranceo uaranteed rene#able ! giving insured the right to renew w)o a medical, usually at a higher

premium based on the attainted age ! age when policy is renewed. Muaranteed renewable means



insurer must renew, but the premium for each class may not be guaranteed. This ends at somespecific age

o uaranteed continuable ! insurer must renew at the same premium

o ( Cost of Living rider ! allows policyholder to buy additional term insurance eual to the 6

increase in the 2PI with no evidence of insurability• 2ost of living changes, make sure it matches cost of living at a future date

o ( Family Coverage rider ! adds a dependent to a term policy of the life insured. It's not available

for group planso ( isability rider ! pays the premiums of a term or whole life insurance policy in the event that the

insured becomes totally * permanently disabled• @iss premiums if you became disabled and couldn't pay fir it

roup Term Life Insurance ! always yearly-renewable term insurance. It provides low-cost coveragethrough an e)er or association and is often convertible to an individual policy within # days after leavingthe group. The advantage is its low cost in providing coverage for everyone in the group. The premiums areusually lower due to lower marketing costs, but they may not be cheaper than a private, individual termpolicy since the coverage pools all risks. The disadvantage is that it's prohibitively expensive for olderworkers to convert to an individual plan

- 9ig problem #ith term insurance ! insurance companies won't insure people that have preexisting

conditions adverse selection problem- (s you get older, life insurance gets very expensive- 7nly covers you for the period you have the insurance

5% 4ermanent Insurance (&hole Life Insurance)

- 4ermanent insurance policy provides lifetime protection for the policyholder, and except for term-to-, is life insurance with a savings or investment component

- 7nce in force, permanent insurance policy can be terminated by insurer only if premiums aren't paid- /ith all life insurance policies, in order for an insurer to offer this type of protection ! to meet its

contractual obligations to the insured to pay the death benefit ! the insurer must set aside funds in apolicy reserve to pay out the future liability, which is comprised of both the death benefit * the savingscomponent

- ;undamental principle ! insured receives NlifetimeO protection- In term insurance - protection is in effect for only a fixed period of time ! a predetermined B of years.

7nce term expires, insurer is released from its contractual obligation. 3owever, in permanentinsurance - coverage is in effect for the life of the insured and therefore the premiums collected must beset aside 0(nd invested% by insurer to pay out its future claims for a much longer period of time. (s aresult, premiums for a permanent insurance policy are greater than premiums for a term policy

- Pure cost of insurance increases exponentially with age ! shown in mortality table in ch. C.- In early years of a whole life policy, excess premiums are building a pool of money called a reserve that

will help finance the future pure costs of insurance when this cost becomes larger than the premium.o ;or these " reasons, the length of the contract * the increasing cost of providing insurance coverage

as a person grows older ! the cost of the pure insurance coverage for a permanent insurance policyfor a younger person is much greater than the cost of term insurance

Cash !urren$er *alue- The premium for permanent insurance is made even higher 0other than for term-to-% b)c an excess

amount of overpayment is added to the premium, which is invested to create a cash surrender value(C0), also called a cash value, which grows over time.

- ( policyholder can borrow against the 2& and pay interest on the policy loan.- If policyholder terminates a permanent life insurance policy early ! surrenders the policy before death !



insurer is then released from its contractual obligation under the insurance contract. The insurance co.will then return the 2& to the policyholder and will retain the balance of the reserve fund, which hasbeen accumulating, to pay the future liability

- " types of permanent insurance policies# o Term*to*+,, 0no 2&% ! also included here b)c it provides coverage for life but it's term insurance

! it has no savings component, no 2& and so, no loan value, and it doesn't pay dividends ! it's not

participating 4ike other insurance policies, it can be a +oint-life or last-to-die policy

ometimes policy pays out the face value at even if insured is still alive

Term-to- insurance is usually purchased by people in mid-life who decide they needpermanent insurance and for whom whole life would be very expensive

o &hole life ! provides lifetime protection * generally the premiums are level ! they remain the same

throughout the policy * the policyholder. (s a result, it is much more expensive than term life inearly years, but becomes cheaper than term much later in life.

The savings component 02&% or cash value, can be used to save for retirement on a tax-deferred basis since the accumulating 2& isn't taxed until it's withdrawn when the policy isterminated 0surrendered%

" basic types of whole life policies$• /rdinary lifeJstraight life – has continuous, level premium * provides protection for life

• Limited payment life – whole life policy where premiums are limited to a specified period

of time ! , " or # years or even premium ! but protection continues for lifeo -niversal life

%eatures of Whole Life Policies- The savings component of a whole life policy means that whole life policies have attributes that term

policies can't have. The savings component as well as the liability for future claims are invested in apolicy reserve> which earns investment income

- There are + forms for permanent life insurance#1. 4articipating Life Insurance – insured NparticipatesO in the reserve profits. Gy law, actuaries are

reuired to make conservative estimates on that portion of the policy reserve that generates theguaranteed 2&. (ny excess income earned by insurer is then shared with policyholder in the formof a non*ta1able dividend% (s a result, if reserve fund is profitable, insurer will pay allpolicyholders an annual dividend. 3owever, dividend is not guaranteed and if returns are lessprofitable, dividend can be less than in prior years or even .- 4articipating Life insurance is permanent life insurance with a savings component 0called

Ncash surrender valueO%. Participating life insurance policies allow policyholders to share inthe reserve profits of a life insurance company. If the reserve fund is profitable, the insurer willpay all the policyholders an annual dividend.o Part of your premium is going into a reserve of money that insurance co. is investing in

behalf of you. If you cancel the policy, you get that reserve of money, which is the cashsurrender value. If reserve does well, you get a share of that ! get a dividend

". .on*4articipating Life Insurance – , $on-t really .orry a/out this, almost all is participating- Insurer assumes all risks associated with its reserves. If insurer underestimates its future claims,

it's responsible for making up the difference in funding for those future liabilities. 3owever, ifinsurer overestimates its future claims, insurer generates extra profits from fund, the policyreserve that's set aside to pay the future liabilities. Insurance co's seldom underestimate bothfuture liabilities and the return it can generate on the reserves, but it does happen.



- ( non-participating policy can either have 0% a 2& in which case the 2& is a return ofpremiums, or 0"% no 2& in which case it's +ust like a term-to- policy

0ifferences /et.een term insurance 1 .hole life#- /hole life has savings component, term life doesn't- /hole life insurance, instead of paying x amount of years, you pay in every year for whole life for rest

of your life and you are guaranteed to get paid out when you die. Term life ! you aren't guaranteed toget paid out

&hich insurance is better! Term or life!

- Depends on your own personal situation. Gy looking at the graphs, if you are young, term is cheaper.If you are a female, it will be cheaper than male. If you don't smoke, it will be cheaper than asmoker, etc.

- If you buy term insurance, problem is that as you get older, insurance costs more each year. It getsreally expense.

- Term to is cheaper than whole life insurance b)c whole life has cash surrender value, whereasterm to doesn't. Jxtra money you are paying is forced savings going into the reserve for you

0allows to save for your retirement%

Types of Whole Life Insurance- Term*to*+,, (no C0) ! term insurance that's so long that it looks like whole life insurance b)c no

one really lives to . =o savings component ! no dividends- 4aid-up policies – policy that has not matured, but no further premiums are reuired. 7nce the policy

is paid up, reserve continues to earn income annually, so 2& keeps growing and death benefit

remains in place. ;inite B of paymentso ( paid*up*at*age policy is life insurance coverage that is in force during insured's entire

lifetime, but premium pmts cease at a specific age, when coverage is fully paid up. Policy is setup to be paid up at the inception of the policy

o Limited payment life insurance – life insurance policy that covers insured's entire life, withpremium pmts reuired only for a specified period of years. ( N" payO policy, for instance isone that is set up to receive premiums for " years, at which time premiums cease, but policy

remains in effect 0pay for " years% ! payments are higher, payouts are fixed.o 7educed paid*up policy ! a policy where the 2& has been used to buy a paid-up policy and

the amount of the paid-up insurance is less than the original death benefit- ariable life insurance policies – where premiums are fixed, but death benefit and 2& vary

according to the investment experience of a separate account maintained by the insurer. Jntire reservein the separate account is invested in euities or other investments ! the amount of the insurancecoverage can be reduced, but can never fall below the original face value. The 2& is not guaranteedand there's no guaranteed minimum 2&. It's suitable for insureds that are looking to improve their

return on the savings portion. The risk-return trade-off applies to this type of policy ! the higher therisk, the higher is the expected 0but not guaranteed% return.

o ;ixed premiums, but variable payout based on reserve performance

- 3ndo#ment life policies ! whole life policies where at maturity ! the end of a limited premiumpayment time ! the face value is paid out even if insured is still alive. 1evisions to the Income Tax Actmean that the entire 2& and death benefit are now taxed as income so no longer popular

o Pay out before death 0not popular due to tax treatment% - rare



The K anishing 4remiums – reduces the annual premium ! popular in the 8s- Prof !tory# in C8s, this was the time when the first computers came out and first portable computers

0siKe of a small suitcase% and door-to-door salesmen would carry it. They could show spreadsheets and

calculations, which was popular with insurance companies. They were selling a product calledNvanishing premiumO. It reuired premiums in beginning, but overtime, when premium and investmentreserve builds up, the reserve gets plowed back to cut your premiums so the premiums disappeared.ince interest rates were so high back then, the reserve would get really big b)c they were in a interestsensitive area. C8" ! they drove inflation down ! interest rates started to come down, so vanishingpremiums began to NreappearO. People who were sold this didn't know that it would reappear.o Popular whole life insurance product that reuired initial premiums. (s premiums build up, the

investment performance of funds will cover new costs for policyholder Premiums vanishEo old using computer simulations shown to clients

o ales peaked at same time as interest rates =ot a coincidence b)c what happens to the value of

your reserve pot in interest sensitive areas, when interest rates are high, reserve gets really big

o Product was very sensitive to interest rates. &ery small movements in rates caused premiums to“ reappear”

*anishin Premium” 0efenses- Jarly cases blamed on NrogueO agents- 2omputer illustrations are not contracts

o timulations aren't contracts ! they showed the disappearing.

- tatute of 4imitations had run out- 2annot sue over Nfuture eventsO- Disclaimers were included in Nfine printO

o “Dividends are not guaranteed and are expected to change.”

- 2ourt denied all of these. It became clear in the case that some of the agents had removed that fine

print from their stimulation. o ultimately, insurance companies were found guilty.

The &utcome 2lass action lawsuits found in favour of plaintiffs. There was deception and concealment.o =ew Hork 4ife lost :8 million in class actionA 2rown 4ife Insurance lost :5 million

'oo2# @any vanishing premiums policies were set up in early C8s when interest rates were very high.Policy illustrations showed the premiums ending after the premium offset date> after perhaps )" yearswhen investment income and)or the dividend would be high enough that the insured no longer had to paypremiums. /hen interest rates fell, reserves were not able to continue to fund the premiums *policyholders had to continue or resume paying premiums. ince investment returns weren't guaranteed,policies set up to have vanishing premiums couldn't produce them when interest rates declined. There were

several class action lawsuits and the insurance co's settled.- The difference between a vanishing premium * a paid-up policy is$

o In vanishing premium policy, the end of the premiums is not guaranteed, while

o In a paid-up policy, the end of the premiums is guaranteed since the term of the premiums is

in the contract ! sometimes years, more often " years



Policy Loan- The right to a policy loan means the insured can borrow against the 2&. There's a max. loan of

85)C6 of the 2&. If insured dies while there's a policy loan o)s, the loan and o)s interest, if any, arededucted from the death benefit.- ince the loan reduces the value of the reserve that earns a return, a policy loan deduces dividends.- The restriction of 85)C6 provides a cushion in case the reserve's return is lower in the future. The

limit ensures that the dividend will always offset the interest on the loan. ince the interest on thepolicy loan is more than offset by the return on the reserve fund, the now-smaller dividend can usuallycontinue to increase the 2& and death benefit. 0Jx. 5%

Automatic Premium Loans- Policyholders can elect to have the reserve provide automatic premium loans that pay the premiums

when the premiums are in default by borrowing against the 2& as a policy loan

Premium *acation- ( premium vacation or holiday means the insured can use the 2& to skip premium payments if

there's enough 2&. The insured can then resume payments w)o penalty or cost

A 3ote on Churnin an$ T.istin- (fter a policyholder has built up the 2&, the agent)insurer might suggest s)he use it to buy a better

policy ! one that has more coverage, diff. features, or an improved pmt schedule. ometimes, thepolicyholder is not told that the 2& in the current policy is being used to buy the new insurance. ;ewpolicyholders know that generally$o The policy must remain in effect for a specific period of time, perhaps # years for agent to get -

86 of the commission, ando The agent is not getting any commission trailers after )8 years

;irst - years, you get 2& b)c the person who sold you the insurance is getting paid acommission > commission trailers

- o after )8 years, a new policy will generate new commissions. 7r the agent may have changedinsurers. 3owever, a new policy that uses the 2& to buy a new policy now has no 2& and it willhave to build up again. The policyholder doesn't pay any premiums until the old 2& is used up andmay, in fact, not have needed more insurance or a better policy. /ith no 2&, the policyholder can'ttake out a policy loan or even surrender the policy and receive the 2&. ince the policyholder is older,s)he won't be surprised to find that this policy costs more since the pure cost of insurance is higher

o This practice is called churning or twisting and it's illegal

3onforfeiture 'enefits- (n insured keeps some benefits even if policy is given up. They include$

o urrendering policy for its 2& and all other benefits cease

o sing 2& to buy a reduced paid-up policy

o sing 2& to buy paid-up term insurance eual to original face amount for a limited period

3e. 4oney Policies- These policies are new products that were developed to provide comparable rates of return to other

kinds of savings vehicles. They were developed when tax incentives, mutual funds, and pension funds



caused a decreased in the proportion of personal savings being channeled into insurance products. Theyinclude universal life, limited payment life level or decreasing term and whole life policies where$o The insurer can change the premiums to reflect the actual cost of insurance, or

o The insured can change the face value and)or premiums to reflect the protection reuired

4aturity 0ate- Gaturity of a life insurance policy is the point in time when the death benefit is paid usually when

insured dies. 3owever, " types of policies pay the death benefit to insured if insured is still alive atmaturity date$o Jndowment policies ! a form of whole life policy, pay out at a specific date if insured is still alive

o ome term-to- policies also pay out at the insured's age

&hole Life 7eserves D -se of the ividend

- In ch. C we look at the way an insurer calc. a level premium for a 5-year term policy and the way thereserve builds up to pay claims. 4evel premium means premium remains the same over entire 5 years

- In this chapter, we look at the way a whole life reserve builds when dividend is reinvested. /hy do wecare? G)c the amount of premium can vary a great deal on a whole life policy due to amount ofdividend that's being invested in both the 2& and the death benefit

5ses of the 0ivi$en$ - ividends are a yearly refund of a portion of the premiums to policyholders based on the co's

experience and anticipated costs, that is, they are paid out of the excess of the actual return on thepolicy reserve over a guaranteed rate of return. They are paid out only on participating policies andare never guaranteed. Dividends arise when$o Insurer has paid out less in death benefits and operating expenses than anticipated, or

o Investment returns were higher than returns used in guaranteed portion of the policy

- (nnual dividend can be paid out or used by the policyholder in a variety of ways, and the choice canbe changed after policy is in effect, with restrictions imposed by each insurance co.

- everal dividend options available to policyholders, and the dividend option doesn't effect the

original face of the insurance policy. They are$. The policyholder can elect to receive the dividend in cash% This annual cash dividend is a

return of premium and a portion of the dividend is, therefore, non-taxable. /ith olderpolicies, the annual dividends paid out are sometimes greater than the annual premium, andcreate tax conseuences to the policyholder.

". 2ash can be paid annual to policyholder, but insi$e the life insurance policya% 2ash can be invested in term*li'e deposits, within the life insurance policy, that earn "-

<6 annually, tax-free b)c investment growth within a life insurance policy isn't taxable.3owever, if policy is surrendered or cancelled early, policyholder receives 2& andaccumulated dividends within policy, some of which is taxable

- 3owever, if these cash dividend are left to accumulate interest, they continue

to accumulate ta1*free #ithin insurance policy ! like an 11P. Mood dividendoption for a conservative individual or an investor that doesn't have any11P)T;( contribution room remaining. Permanent life insurance policies withan investment component allow people to transfer some of their wealth to theirbeneficiaries tax-free since the death benefit isn't taxable.

b% Ge used to purchase a$$itional insurance$i. 4ermanent insurance ! known as paid*up additions (4%-%6) ! providing insured

with increasing death benefit and increasing cash value if additional insurance iswhole life. (dditional insurance also earns dividends so the exponential cycleincreases. 0to increase death benefit%.



ii. 4aid-up – one*year term insurance that increases only the death benefitc% Policyholder can elect to use dividend to reduce annual premium ! known as

premium vacation Kvanishing premium b)c dividend is used to pay for annualpremium of the policy

#. ;or universal life policies, but not whole life, dividend can be used to purchase segregated fundsWhole Life Reserves

- @ost whole life policies charge the same premium over the life of the policy. In early years, annual

premium is much higher than the cost of pure insurance. (s insured ages, premium eventually is lessthan the cost of pure insurance each year.- /ith regard to only the death benefit, insurer has excess funds each year in early years, which

accumulates and are drawn down in later years. The excess is stored in a policy reserve thataccumulates to$ 0% Pay the death benefits, and 0"% hold the cash surrender value

- The load 0charge for admin, marketing * selling costs as well as profits% is subtracted from premiumfirst, and then the mortality charge, which is about the same as a term life premium, is subtracted. /hatis left is put into the reserve to earn approx. <6 a year. G)c this reserve is reuired by law, it is alsocalled the legal reserve and it continues to grow as long as insured is alive. It's called theaccumulating reserve in the Income Tax Act 0IT(%

- The amount at ris' for insurer is the diff. between the face value of the whole life policy and the 2&

at any point in time. /hen insured dies, insurer pays out the death benefit 0the face value% and keepsthe 2&. (s a result, the amount at risk decreases as insured pays premiums and 2& grows- The net amount at ris' is the face value of the policy minus the policy reserve and it also declines

throughout the life of the contract. The net amount at risk is the insurer's exposure ! the amount theinsurer would have to draw from its own funds rather than the policy reserve were the insured to die. (sinsured continues to pay premiums, reserve grows and the net amount at risk decreases. In other words,from the insurer’s perspective, the actual insurance coverage is decreasing, that is, the death benefitremains the same while the reserve continues to grow. ;or the insurer$o The cost of pure insurance > face value of policy ; probability of dying, which increases every

year and can be seen in the mortality tables in ch. Co The net cost of pure insurance (.C4I) > probability of death ; net amount at ris'

Increases each year for " reasons$ person is aging, or death benefit 0both guaranteed portion9 non-guaranteed portion is increasing%

4olicy Illustration 0don't think you need to know this%- /hen a person buys a whole life policy, the insurer provides a policy illustration that shows$

o The uarantee$ cash value (C!*) and uarantee$ $eath /enefit Policy guarantees a certain

2& and a guaranteed death benefit. These are the amounts the insurer must pay out for the 2&if you cash in the policy or for the death benefit if insured dies. These amounts will be the sameon all versions of a policy illustration. Muaranteed 2& > for first years in part to pay agent'sst year commission and commission trailers and also to discourage insured's from cashing thepolicy in 0surrendering the policy%. (dded guaranteed 2& doesn't have to be same every year

o ( primary e1ample showing what might happen with the cash value 02&% * death benefit,depending on$

The options chosen for the dividend,

The nonuarantee$ cash value * death benefit if the dividend it used to buy insurance, and

The results for non-guaranteed portion if returns are less than return used in primary example

.on*guaranteed cash value reflects the amount from the dividends * depends on therate of return earned by the investments in the reserve fund 02& * death benefit do increaseevery year as reserve grows, but amount depends on return earned by policy reserve% Thepremium is sufficiently high generate a non-taxable dividend that could be paid topolicyholder, but, more often, is allocated to the policy reserve.



• Total cash value – 2& from both guaranteed * non-guaranteed

• Total death benefit – total face value from both guaranteed portion 9 non-guaranteed

face value purchased using some of the dividends to buy paid-up insurance

• (dditional illustration would show amount of cash value * death benefit if return is

lower. 2an't calc. amount of policy reserve w)o interest rate being used and loadingcosts being charged to policy

LL onMt need to understand Table 8%6>9>C 0pg. "C#-"C%

- 4ortion of C0 is only ta1able if policy is cashed in ! surrendered ! since death benefit is paid aslump-sum isn't taxable.

- If insured dies, the face value or death benefit is paid out and insurer keeps the reserve. The cashreserve 0or 2&% is paid to policyholder only if$o Policy is cancelled and policyholder receives 2&, or

o If policyholder takes out a policy loan. If insured dies with a policy loan o)s, the loan is deducted

from the face value- 0urrender charge is the cost to cancel a policy and it reduces the 2&

o &hole life: surrender charges are high in early years, usually eual to 6 of cash value. They

decrease over time, but generally don't disappear until year "o -niversal life: an estimate of this cost is the annual minimum charge L the B of years the policy

is in force L some 6 based on the age of the contract. The surrender charges are often provided inthe contract

o 0egregated funds: the cost is some 6 of the amount redeemed. It's similar to a deferred sales

charge on a mutual fund.

4aximum !avins Component – Exempt 1 3onExempt Policies- The Income Tax Act doesn't allow the savings component to receive excessive deposits so it has

rules about how large the policy reserve 0accumulating fund% can be relative to the siKe reuired topay the death benefits 0mortality costs% and expenses. (pplies to policies written after Dec.", C8"

- 31empt policies meet the reuired criteria and are exempt from a special tax. randparentedpolicies are exempt whole life policies that were acuired before Dec. ", C8".

- .on*e1empt policies don't meet the reuired criteria ! insured have made deposits in excess of theamount needed to fund the death benefit and provide a reasonable level of savings. The excess gainis reportable and taxed whenever the policy is in a gain position regardless or whether or not the gainhas been realiKed. This aspect is impt. when investing in universal life, which allows thecontributions to vary

Comparison of Costs of Temporary and 4ermanent Insurance

The following comparison is based on$- ( +,*year term policy that's renewable * convertible ! it can be renewed w)o a medical up to age 8

and can be converted to a whole life policy before age 5. @ost policies are renewable and convertiblealthough the age restrictions will vary. Premiums for renewing and)or converting are set when policy is

issued and are based on insured's attained age at renewal or conversion- ( term*to*+,, policy> usually bought by someone at 5 or older who wants permanent insurance- ( #hole life policy with premiums payable until age , at which point coverage continues, but it has

become a paid-up policy. 7ther options include premiums payable for yrs, "yrs or to age 5- 2omparisons cover " #-year-olds ! a male smoker 0most expensive%, female non-smoker 0least

expensive%.



31%H: Foanne * Don recogniKe they're underinsured and want to look at the options. /hile they feel theyneed insurance only for about " years, they have heard about other types of policies and want to know notonly the cost of various types of insurance, but the rationale behind the various costs. Premiums are the costfor the length of the term of the policy

- P6 +78 Ta/le 869A# Comparison of Term 1 Whole life annual premiums for a :9;;2 Life Insurance Policy issue$ at ae "; shows annual premium, which is the same every year for theterm covered, varying from years to age for the # types of policies. It's obvious if you areyoung and money is tight, a -year term policy has a great deal of appeal

o hows dramatic increase in rates for female non-smoker. The term policy, providing only

insurance coverage with no savings component, is much cheaper in earlier years, but sincerate is determined by person's age, it becomes increasingly expensive as it is renewed every years.

- P6 +78 Ta/le 869'# Comparison of <;yr= termto<;;= an$ .hole life annual premium of a

:9;;2 Life Insurance Policy issue$ at ae "; compares from age # to age C. omeone forwhom money is very tight might take a -year policy even though the children are +ust born b)c

s)he might assume things will be better in years when policy has to be renewedo +,*yr term policy renewed several times and ending at age C, which reflects an initial

temporary need for insuranceo Term*to*+,, policy reflecting a permanent need for insurance but no need for a savings

componento &hole life policy with premiums paid until age , which reflects a desire for permanent

insurance. This policy pays out a death benefit 0face value% on the death of the insured andthe insurer keeps the 2&, that is, the beneficiary does not collect both the death benefit andthe 2& on the death of the insured

- P6 +77 Exhi/it 86<# Annual Premiums for :9;;2 of Coverae

o ntil age 5-5C, -year term is cheapest, then its higher then the resto Term-to- is cheaper than whole life at all ages?

o (fter age 5, term-to- is cheapest, then whole life

- P6 +77 – Ta/le 869C# P* at ae "; of the premiums if the policies are hel$ for +; yearso Term-to- and whole life have payments spread over a diff. number of years, which affects the

amount of the premium- /hy the big difference between yr term, term-to-, whole life premiums to age ?

o The basic rates for insurance coverage is based on mortality rates 0rates of dying%. ince

premium is the same throughout the term, term-to- and whole life charge a lot more inearly years when mortality rates are low and relatively less in later years when people aredying at a much higher rate

o /hole life premiums have a built-in savings component, the cash value, which adds to the

cost

P6 ";; – Ta/le 8690# P* at ae "; of the premiums if policies are hel$ as lon as possi/le- 2ompare the P& of the premium for the same # policies but for more than " years$

o yr term policy renewed as long as possible, in this case, providing coverage for years

ending at age Co The entire years of a term-to- policy



o The whole life policy where premiums are paid to age

- If Don * Foanne are certain they will need insurance for only " years 0up to age 5%, they shouldbuy a term policy b)c it will be the cheapest by far

5sin a Policy Loan to %inance Retirement - Don and Foanne have a pension at work, which means they may not have very much 11P

contribution room. They also can save a total of :, a year for both short and long-term plans in

a T;(. 3owever, they should know the possibilities for using a whole life policy to save forretirement.

- This is also attractive for small business owners who may need life insurance coverage for a longertime than Foanne and Don. This can be achieved w)o cashing in the policy by taking out a non-taxable policy usually limited to 85 or C6 of the 2&

31% <: If you have whole life ! you can take loans out of the euity you have 02&%.

- 4g% $,, understands the conceptA don't need to know the calculations.- P6 ";< – Ta/le 86># Comparison of Atax C!* .ith effect of policy loan at ae 9?

Terry, Foanne's brother is part of a partnership and is also married with young children. Terry chose thepolicy in Jx. 5 0pg. "C#% so that, by age 5 0at the end of policy year #5%, the policy has a death benefit of

:",55,58 and a 2& of :,",##.- If he surrenders the policy, he receives :8C,"C a-tax 0table 8. ! pg. #% and has no insurance

coverage 2an surrender your policy and get the cash value ! then you don't have life insurance- If he takes out a policy loan, he receives :,",## 0856 x cash value% and still have :,<85,<5< in

death benefit coverage. ( smaller policy loan would provide a larger death benefit.o Hou can get a loan against the cash value and keep the whole life insurance in place

- (s shown in Jx. 5, the policyholder has been paying a higher premium to add a lump-sum to thereserve in order to participate in the returns of the return. (fter the policy loan, the reserve continuesto earn income each year and the resulting dividend continues to increase the death benefit. Theinterest charged on the : million policy loan will be offset by the dividend being generated by the

reserve fund. The insured has collaterally assigned part of the death benefits to the insured, thecollateral being the death benefits. /hen the insured dies, the insurer deducts the policy loan andinterest, if any, from the death benefits and pays out the net of :,<85,<5< to the beneficiary.

- These examples assume the entire policy is surrendered and the policyholder receives the entire2&. ;or the amount of the investment, the " pay policy reduces the largest 2& compared topremiums paid 0in this example anyway%, while collecting the entire dividend products a low returnalthough this example doesn't show the result if the dividends received were invested outside thepolicy.

- ( policy loan of 85-C6 of the 2& is not taxable when received

-niversal Life Insurance

- /hole life insurance, but it can be tailored to meet the needs of an individual. 2an changecomponents at any time.

- ( -niversal Life insurance policy is a permanent form of life insurance that can be custom tailoredto meet an individual's needs. The various components of a universal life policy are flexible andunbundled, and can be changed at anytime while the policy is in force.

- 9undled refers to the various component parts of a life insurance policy that are connected to eachother ! who is covered, investments, premiums, face value, and 2&. The insured can$

o 2hange the initial face value 0face amount at

the issue date%o Increase or decrease the death benefit

o 2hange a level death benefit to an increasing

benefito ubstitute one life for another



o 2hange the amount of the deposits 0premiums%

o 2hange the freuency of the deposits

o 2hange the investment strategy

o Take out a policy loan

o ometimes withdraw cash w)o terminating the

policy and w)o this withdrawal being a policyloan, and

o @ight be able to add other insureds

- The premiums, above and beyond the cost of the insurance, known as contributions or deposits> can beincreased yearly to accumulate within the policy and are exempt from tax if left in the policy. 3owever,if they are withdrawn, they result in taxable income. ;unds in a universal life insurance policy can be

invested in segregated funds and the income received from the segregated fund is also exempt from taxif left in the policy

- The contribution or deposits are known as the cash value of the universal life policy% The cash valuecan be withdrawn w)o terminating the policy 0this is not a loan%, and policy loans are permitted

- 7ther possible features are$o The savings component can have " interest rates ! one that is guaranteed minimum, another that is the

current rateo The expense charges can be front-end, back-end or both

o (n investment bonus of -.56 p.a. might be paid to encourage insured to keep the contract in force

o ( side fund might be available. It is$

0% Jxternal to the policy, 0"% not included in death benefit, 0#% doesn't affect net amount at risk,and 0#% the deposits aren't sub+ect to PT

o ( variable mortality cost option permits the mortality cost factor to be revised each year to reflect

the mortality experience of the insurero 2early term rates can allow prems. that are based on attained age, that is, premiums increase each yr

- In other words, almost every aspect is flexible- Insurance agents often provide policy illustrations that illustrate what could happen. ince these policies

cover a long period of time, small changes in assumptions about rates can make a large diff. so a potentialinsured should look closely at assumptions. 3owever, actual results of universal life policies, unlike wholepolicies, is totally transparent and insured can see exactly what happened to the investment in the reserve

0eath 'enefit &ptions for 5niversal Life- Insurers offer a variety of options for calc. the amount of death benefit and these options are dependent

on the new amount at risk 0from the insurer's point of view% b)c it varies with the settlement option% Thenet amount at risk is$

9 amount of the death benefit payable-- amount in the policy reserve 0account value)

- The most common are$. Level death benefit – the face value doesn't change over the life of the policy. This is the

cheapest b)c the amount at risk decreases over the life of the policy as the account value grows.The beneficiary receives the face value and the insurer keeps the account value

". Level death benefit N accumulated premium deposits ! this is one of the most expensive sincethe benefit is increasing to include essentially a refund of premiums after the insured dies. Theamount at risk increases with every premium payment

#. Level death benefit N account value ! also expensive since the amount at risk grows with theincrease in the account value

<. Inde1ed death benefit ! the death benefit increases on a compounded basis every year. This isalso expensive since the face value is continually increasing



Comparison of Life Insurance 4olicies ! Table 8%8 – pg% $,$

&hole Life -niversal Life Term*to*+,, Term

Period ofcoverage

4ife ;lexible 0usuallypurchased for life%

To age -5, usually notavailable after age5L

Premiums Muaranteed, usuallylevel

;lexible Muaranteed, level Muaranteed forterm

2ost sually higher in earlyyears, but lower thanterm in later years of thepolicy

;lexible @ore than term, butcheaper than wholelife

2heapest form oflife insurance

Death Genefits Muaranteed and canincrease depending on

the dividend optionselected for the policy

;lexible Muaranteed Muaranteed

2ash surrendervalue 02&%

Muaranteed and canincrease depending onthe dividend return

;lexible sually none =one

DividendsLL Hes, usually ifparticipating

sually no sually no =o

; This depends on the insurance co. that is offering the protection. 3owever, term policies after age 5 arerate in 2anada.LL Dividends from mutual life insurance co's are a refund of premiums and aren't taxableDividends from stock life insurance co's are taxed as regular dividends

4g% $,$ * Table 8%= – 6dvantages and isadvantages

6dvantages

&hole Life

- Protection for life- 4evel premiums- 2an borrow against,withdraw or use to paypremiums- Dividends received arenon-taxable

- 2an be used to transferwealth

-niversal life

- ame as whole life- (daptable to changingneeds of insured- Insured controlspremium- Insured controls theinvestments

- 2an be used to transferwealth

Term*to*+,,

- Protection forlife 0age %- 4evel premiums- 2heaper thanparticipating lifepolicies

Term

- Mood for short-term needs0like a mortgage%- 2heaper than permanent- 7ften can be converted to apermanent policy without amedical

isadvantages



&hole Life

- 3igh initial cost- =ot efficient for short-term needs- 2& is small in earlyyears

-niversal life

- 3igher admin expenses- 2omplexity makes itmore difficult to manage- Insured bares soleresponsible forinvestment returns

Term*to*+,,

- Policies are non-participating

Term

- Premiums increase with eachrenewal- 1enewability stops at 5)- If premiums not paid, policycancelled in # days and maynot be reinstated w)o a medical

- sually no 2&

0egregated Funds (03 F-.0)

- The legal name of a egregated ;und is individual variable annuity contract – it's an annuitycontract between an insurance co. and the policyholder in which the policyholder deposits money,known as contributions or premiums> in an insurance trust> which is used to invest in a variety ofproducts to achieve a specific mandate.

- These funds in the trust are kept separate 0segregated% from other assets of the insurance co. and belongto the policyholders of the trust

- 31% a fixed income segregated fund policy would invest a fixed income fund 0trust% that in turn wouldinvest in a variety of fixed income products

- 7wner)policyholder)beneficiary)annuitant buys a fixed income segregated fund policy 0an individual

variable annuity contract% that invests in a fixed income fund 0a trust% that invests in fixed incomesecurities

- The o#ner of a segregated fund, unlike a mutual fund, is the policyhol$er of the individual variableinsurance contract and is also the /eneficiary or annuitant of the trust from the funds income%

- The policyholder is in a deferred annuity contract in which the policyholder promises to pay moneymonthly in the form of a premium to the insurance co. who, in return, manages the JM fund and

further guarantees at least 56 of the investment if the policyholder leaves the money in the fund untilthe maturity date ! some specified period of time in the future, such as years from the date of thecontract

- The assets in a segregated fund are kept separate 0are segregated% from the assets of the insurance co.and are, in turn, invested in various products, such as a money market fund, a bond fund, a balancedfund, a growth fund, etc. 4ike mutual funds, these segregated funds have specific investment mandatesand the money collected from policyholders is held in trust to carry out the investment specified by thefund

- 7nly insurance co's can sell JM funds which can be all or part of the investment portfolio of a 4policy and can also be purchased directly

- 7nly 2anadian residents can purchase JM funds, but they can keep them if they subseuently become

a non-resident

&vervie. of Investment %un$s- (n investment fund pools each investor's money with the money of other investors in order to buy a

basket of investments. Jach fund might include as many as or more diff individual securities orindices

- @utual funds and JM funds are the " more popular types of investment funds although there are also$o Labour sponsored investment funds (L0IF) that invest in small to mid-siKe, unknown, +unior

companies. They are venture capital funds that invest in private euity and are only available to2anadian investors. 4I; provide federal * provincial tax credits to the investor who agrees to



invest for a minimum B of yearso Income trusts such as$

7oyalty and energy income trusts invest in oil, gas or other natural resources

7eal estate investment funds (73IT) invest in income-producing properties such as officebuildings, shopping centers and apartment buildings

-tility trusts invest in pipeline, power and telecommunications companies

9usiness investment trusts invest in various business

o Income trust funds or income funds are mutual funds invested in income trusts

4utual %un$s- ( mutual fund corporation is an open-end corporation, meaning it must provide shareholders the

right of shares redemption, which a closed-end corporation and a closed-end mutual fund don't. (mutual fund corp. may elect to pay capital gains by declaring a special capital gains dividend which istaxed as capital gains income to the investor

- (n open*end mutual fund issues new shares whenever an investor invests in the fund and also when itdistributes mutual fund income. The fund value, the .et 6sset alue (.6)> is the market value of the

investments and units can be redeemed at any time at their net asset value per share (.640)% @ostmutual fund trusts are open-end mutual funds

- ( closed*end mutual fund is a fund in which the total B of units its fixed. (fter the initial offering, theunits can be acuired only from another owner. nit prices of closed-end funds are set by supply anddemand, not net asset value, and are traded on a stock exchange

Comparison of 0egregated Funds #ith Gutual Funds

- JM funds and @;s compete for investor dollars. They have many things in common, and many diffs.

- 5ni@ue %eatures of !ereate$ %un$s# they have " features that @;s don't haveA although they differ inthe way they are taxed. egregated funds offer$

o ( guarantee of some or all of the investment, ando (s an insurance policy, some of or all the death benefit and the maturity value can be creditor-

protected+% Capital uaranteed

- JM funds provide policyholders a guarantee on the principal investment. The guarantee isusually based on the principal investment over a period of time and specified in the policycontract, that is, the insurer will guarantee the policyholder that it will return it to them eithero (t maturity of the policy, typically years, 56 or more of the capital, or

o ( death benefit guarantee, which can be 6 of the capital and carries a higher fee since

the insurer might set aside more in the reserve for this guarantee5% Creditor 4rotection of the Insurance 4roceeds

- 4ife insurance proceeds with irrevocable named beneficiaries who are a spouse, children,grandchildren and parents don't pass through the estate, and therefore, aren't available tocreditors of the investor at his or her death. This is attractive to owner-managers of businessesand professional practitioners.

- In addition, JM funds can't be used as collateral on a loan, and policy loans aren't permitted

!imilarities- Goth provide professional money management for the investor- Goth are eligible investments for non*registered savings, for registered savings such as 11P,

4ocked-in 1etirement (ccount 04I1(%, 4ocked-in 11P 041P% as well as registered retirement



income plans that are paying retirement income such as 1egistered 1etirement Income ;und 011I;%, a4ife Income ;und 04I;%, 4ocked-in 1etirement Income ;und 041I;% and a Prescribed 1etirementIncome ;und 0P1I; ! available in askat and @anitoba only%

- Goth provide diversified investment options since each fund has purchased several investments inspecific categories. These funds can be as follows$o 9alanced funds invested in cash-euivalent investments, bonds and stocks

o 9ond funds or (fi1ed) income funds invested in govn't bonds, high-uality, high-yielding

corporate bonds, high-yield preferred and common shares, and mortgageso ividend funds invested in 2anadian preferred and common shares yielding high dividends

o 3merging mar'et funds invested in small countries that are expected to grow

o 3thical funds guided by some moral criteria

o lobal funds invested in well-diversified portfolios from every ma+or economic region in the

worldo ro#th funds that are more volatile 0and therefore more risky% euity funds

o International funds invested outside of 2anada, such as bond funds, Fapanese growth funds,

;at Jast ;unds, and Juropean euity fundso Goney mar'et funds invested in safe, short-term liuid investments

o Gortgage funds invested in high-uality 0first% mortgages and maybe short-term bonds

o 7eal estate funds invested in income-producing real estate such as apartment buildings, office

buildings, shopping malls and industrial buildingso 0pecialty funds invested in$ 0% pecific industries such as oil and gas, or 0"% specific segments of

the capital market such as natural resources * precious metalso Treasury*bill funds invested only in govn't of 2anada t-bills

- Goth charge a management e1pense ratio (G37) to cover expenses ! commissions, brokerage fees,legal and audit, safekeeping charges, management fees, transfer fees and taxeso ( portion of the @J1 in a JM fund is used to buy insurance, which allows insurer to offer a

guarantee on the investment. The insurance guarantee increases the @J1 on JM funds by ."5-.56 depending on the fund's risk profile and the amount of the guarantee

- P6 ";> – Ta/le 86<;# 0ifferences /et.een !ereate$ %un$s an$ 4utual %un$so tructure, 1egulation, 2reditor Protection for the ;und, 2reditor Protection for the Investor, &alue,

Muaranteed &alue, @J1, 1edemption, Death Genefit, Proceeds at Death, Probate

TaxationIncome that flo#s through these funds mean the income N7etains its natureO

- If the fund received dividends from a ta1able Canadian corporation> the recipient will first gross up this income by +@B to arrive at a ta1able dividend income and then will use the dividend ta1credit of +8%=HB to reduce the ta1 payable. This means that /oth the gross-up and dividend taxcredit have flowed through$

- ;or capital gains, only ,B of o .et capital gains is taxable for mutual funds

o Capital gains and capital losses is taxable)tax-deductible for segregated funds

- (ll interest income as #ell as dividends from foreign corporations never have any special taxtreatment regardless of where they are invested ! they are +,,B ta1able so while technically theincome may flow though, it doesn't have any effect. 3owever, any foreign non*business ta1 credit

arising from tax withheld by foreign govn'ts on interest and dividends earned in foreign countries alsoflows through

The effect on the recipient's income taxes depend on whether or not the funds are held in a registered of



non-registered account$- If the funds are held in a registered account> such as 7704, the income received by the recipient is

not ta1able until itMs #ithdra#n from the registered plan, at which point it is +,,B ta1able. Theeffect is that the income does not flow thougho This is the same with all investment income earned by a registered plan, that is, income is not

taxed until its withdrawn, at which point it is fully taxable. /hile registered plans allow incometo grow before tax, it al.ays loses its nature and become 6 taxable when withdrawn

- If the funds are held in a non*registered account 0except a ta1*free savings account where theincome is never ta1ed%, the income is ta1ed annually by the recipient 0Table 8.%

2apital gains * losses are incurred in " ways$. The fund itself has made or lost money investing. These gains * losses can be$

a. 7eali?ed – the investment was sold, orb. -nreali?ed ! the fund is still holding the investment

". The investor sells units in the funds at a gain or loss

a. ;or mutual funds, the capital gain is the proceeds from the sale after any fees minus thead+usted cost base. (ny increase in the 6C9 #hile the units are held #ill decrease theamount of the capital gain 0of #hich ,B is ta1able%

b. ;or segregated funds> the capital gain is the proceeds from the sale /efore the fees minusthe ad+usted cost base. The fees are deducted as a capital loss

c. Capital losses can be deducted only from capital gains from the prior $ years or carriedfor#ard indefinitely. Dividends * interest, both domestic * foreign are received by thefund from its investments

1eturn of capital is a distribution that is over and above the annual income of the fund

- P6 ";7 – Ta/le 86<<# Taxation 1 Allocation or 0istri/ution of Income Earne$ /y the fun$

o LL Don't need to know the calculations, +ust know the tax treatments for both ie. #hat isthe difference in the #ays capital gains are treated

o Type of 7rganiKation, Distribution of Income after @J1 * Taxation of Income 1etained in

the ;und, Jffect of Distribution, ;low Through for =on-1egistered Plans, Jffect for1ecipient, Prorated Distribution, Qeeps Track of (2G, ales 2harges, Taxation of1edeemed nits, 1eturn of 2apital, nrealiKed 2apital Mains * 4osses from the ;und, 1eset

!li$es for sereate$ fun$s#• imilar to mutual funds sold by insurance companies

– 2apital is guaranteed at maturity of policy•

Principal is guaranteed 0usually 6%– Proceeds are unavailable to creditors

• G)c they are insurance policies ! they can't be ceased by creditors– Portion of @J1 used to insurance for capital guarantee

• @anagement expense ratios are high ! part of the @J1 is used to buy the insuranceto insure the capital 0euity options%

– Difference in tax treatment• They are taxed differently than mutual funds. 4ook at figure 8., 8.

- 4egally they are called individual annuity contacts



- egregated funds are conceptually like mutual funds

fin512 chapter 8 - life insurance

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