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Life coverage and Annuities

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  1. Life Insurance and Annuities • Terminology • Types of life insurance products • Tax treatment of life insurance • Term insurance • Endowment insurance • Whole life insurance • Universal insurance • Variable insurance Ins301 Chp15 –Part1

  2. Terminology • Death benefit = amount beneficiaries receive • Cash value = amount of savings accumulation • Death protection = amount of pure death protection = death benefit - cash value • Face amount = stated amount of coverage = death benefit (for term, whole life, & some universal life) = death benefit - cash value (for some universal life) • Cash surrender value = the amount of money that the policyholder can withdraw (=cash value - surrender penalty) Ins301 Chp15 –Part1

  3. Life Insurance Products: General Introduction • Term insurance • pure life insurance • Cash value life insurance • pure life insurance + Savings accumulation • whole life • universal life • variable life • Variable universal life Ins301 Chp15 –Part1

  4. Tax Treatment of Life Insurance • Death benefits are not taxed • Income tax is not paid on increases in cash value while the policy is in force • Upon surrender, income tax is paid on Cash surrender value - sum of all premiums + sum of all policyholder dividends Ins301 Chp15 –Part1

  5. Implications of Tax Treatment • Implicit returns on savings accumulation • Escape taxation if insured dies • Tax deferred if the policy is surrendered • Partially taxed if policy is surrendered • Amount which is taxed is less than implicit return b/c part of premiums is cost of death protection Ins301 Chp15 –Part1

  6. Term Insurance • Typically provides pure death protection over a fixed term, usually one year or five years. There is no savings feature and therefore no cash surrender value. • Data • 1/4 of policies • almost half of death protection purchased • Guaranteed renewable • Premium increases over time. Why? Ins301 Chp15 –Part1

  7. Life Insurance Pricing • Ignore expenses and risk load ==> focus on net premiums • Use mortality table • Probability of dying at age x conditional on living through age x-1 • Example: Probability of male dying at age 40 = 0.00302 • Assume • Premiums paid at beginning of year • Claims paid at end of year Ins301 Chp15 –Part1

  8. Pricing 1-Year Term • Find fair premium for $100,000 1-year term for 40 year-old • Interest rate = 10% • Insurer’s cash flows: Beg. of Year End of Year $100,000 with prob 0.00302 Loss $0 with prob. 0.99698 Expected claim cost = ________ Premium = Present value of expected claim cost = __________ Ins301 Chp15 –Part1

  9. Pricing 1-Year Term • Find fair premium for $100,000 1-year term for 41 year-old • Interest rate = 10% • Insurer’s cash flows: Beg. of Year End of Year -$100,000 with prob ____________ Premium $0 with prob. ____________ Expected claim cost = ___________ Premium = Present value of expected claim cost = ____________ Ins301 Chp15 –Part1

  10. Pricing 1-Year Term • Premium increases as probability of dying increases Ins301 Chp15 –Part1

  11. Pricing 2-Year Term • Find fair premium for $100,000 2-year term for 40 year-old • Insurer’s claim costs: Beg. of Year 1 End of Year 1 End of Year 2 -$100,000 -$100,000 with prob 0.00302 with prob x $0 $0 with prob. 0.99698 with prob 1-x Ins301 Chp15 –Part1

  12. Pricing 2-Year Term • What is x? – it isthe probability of a 40 year-old dying in his 42nd year? • Mortality table: Number Number Age of People of Deaths 40 937723 2832 41 934891 3076 Probability of 40 year-old dying in 41st year =_____ = ______ Probability of 40 year-old dying in 42nd year =_____ = ______ Ins301 Chp15 –Part1

  13. Pricing 2-Year Term • Single premium • Level Premium Ins301 Chp15 –Part1

  14. Endowment Insurance • Pays face amount if the insured dies, or if the insured survives the policy period • It is similar to a saving account • The US no longer grants tax advantage to endowment policies unless they have a very long duration, such as whole life insurance. Ins301 Chp15 –Part1

  15. Whole Life Insurance • Policy period ends when insured reaches 100 • Equivalent to endowment policy to 100 • Premiums • single premium • limited pay – a level premium paid for a 10-year or 20-year period • continuous premium – level premium continue until the policyholder dies, surrenders the policy, or reaches the age of 100 (whichever comes first) Ins301 Chp15 –Part1

  16. Whole Life Insurance • Premiums generally do not increase over time • But probability of dying increases over time ==> higher upfront premiums than with term • Policyholder “prepays” part of the cost of future death protection • entitled to prepayments if policy is surrendered • this is the cash value (savings accumulation) Ins301 Chp15 –Part1

  17. Whole Life Insurance • If insured dies, • beneficiaries receive face amount = death protection + cash value • Structured so • cash value  over time • death protection  over time Ins301 Chp15 –Part1

  18. Whole Life Insurance Ins301 Chp15 –Part1

  19. Pricing Single Premium Whole Life • Apply same principles used with term insurance • Forecast expected cash flows to age 100 • Find single premium = PV of expected cost • Assume • no expenses or profits • 5% interest rate • policy will not lapse Ins301 Chp15 –Part1

  20. Pricing Single Premium Whole Life Single Premium Ins301 Chp15 –Part1

  21. Continuous Level Premium Whole Life • Continuous level premium • Same premium is paid until insured dies or reaches 100 • Equivalent to a life annuity • Present value of a life annuity that pays $P starting at age 40 = 16.30 * P • Find P so that PV of premium payments = PV of costs • 16.30 * P = $22,373 ==> P = $1,372.58 Ins301 Chp15 –Part1

  22. Limited Payment Whole Life • Limited payment level premium • Same premium is paid for fixed number of years • Example: 20 years • Equivalent to a 20 year annuity • Present value of a 20-year annuity that pays $P starting at age 40 = $12.58 x P • Find P so that PV of premium payments = PV of costs • 12.58 x P = $22,373 ==> P = $1,778.45 Ins301 Chp15 –Part1

  23. Comparison of Cash Values in Whole Life Ins301 Chp15 –Part1

  24. How Much Life Insurance Should be Purchased? • Rules of thumb • Death benefit = 8 times income • Forecast beneficiaries sources & uses of funds • Uses: • Living expenses • Education expenses • Sources: • Social security • Earnings Ins301 Chp15 –Part1

  25. Participating Policies • Can (and usually does) pay annual dividends • always with mutual companies • often with stock companies • Why? - premiums based on conservative assumptions • Key assumptions: interest rate levels and mortality rates • These variables are correlated across policyholders • Insurer’s methods of dealing with correlated risk: • Bear the correlated risk and hold a lot of capital • Share correlated risk with policyholders • Illustrated versus actual dividends Ins301 Chp15 –Part1

  26. Other Whole Life Policy Provisions • Surrender Options • Take cash value • Use cash value as a single premium for • paid up whole life • term policy • Policy loans • borrow against cash value • interest now varies with market rates • in 1970s & 80s, fixed rate ==> disintermediation • Front-end expense charges ==> Cash value grows slowly at first ==> Implicit return on savings accumulation initially low Ins301 Chp15 –Part1

  27. Universal Life • Similar to whole life • Main differences: • Greater flexibility in premium payments • Cash value does not follow a fixed schedule; it varies with • policyholder’s premium payments • insurer’s expense and mortality charges • rate insurer uses to credit interest to cash value • minimum rate usually guaranteed • rate often linked to short term interest rates Ins301 Chp15 –Part1

  28. Factors Affecting UL Cash Value Ins301 Chp15 –Part1

  29. Death Benefit Options with Universal Life • Level death benefit (as with Whole Life) • Death benefit varies with cash value Death benefit Death benefit Cash value Cash value age age Ins301 Chp15 –Part1

  30. Variable Life • Similar to whole life • Main differences: • Cash value does not follow a fixed schedule; it varies with • return earned on portfolio of mutual funds chosen by policyholder • Death benefit • minimum is guaranteed, but varies with cash value Ins301 Chp15 –Part1

  31. Life Insurance and Annuities (part3) • What is annuities • The purpose of annuity • Classification of annuity • Overview of annuity contracts Ins301 Chp15 –Part1

  32. What is Annuity • An annuity is simply a series of periodic payments. • An annuity contract is an insurance policy that promises to make a series of payments for a fixed period or over someone’s lifetime • It is typically used as long-term retirement funding vehicles. Ins301 Chp15 –Part1

  33. Two Periods of Annuity • Accumulation period -- the period when the policyholder pays premiums to the insurer • Payout period -- the insurer makes payments to the policyholder Ins301 Chp15 –Part1

  34. Purpose of Annuity • Risk management purpose • Reduce the risk that savings are exhausted before the annuitant dies • tax-deferred saving vehicle • Returns earned from these contracts are not taxed until the insurer distribute them Ins301 Chp15 –Part1

  35. Classification of Annuity • Immediate annuity and deferred annuity • Immediate • Deferred • Flexible premium deferred annuities (FPDAs) • Single premium deferred annuities (SPDAs) • Fixed annuity and variable annuity • Fixed annuity • Variable annuity Ins301 Chp15 –Part1

  36. Overview of Annuity Contracts Ins301 Chp15 –Part1