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Unformatted text preview: Dr Mariusz Dybał Institute of Economic Sciences [email protected] Insurance market Life insurance (Based upon: George E. Rejda, PRINCIPLES OF RISK MANAGEMENT AND INSURANCE (10TH EDITION), Addison Wesley, 2007) 1 Mariusz Dybał – Life insurance Scheme of the Lecture 1. 2. 3. 4. 5. Premature Death; Death; Financial Impact of Premature Death on Different Types of Families; Families; Amount of Life Insurance to Own; Own; Types of Life Insurance; Insurance; Case application no. 7. 2 Mariusz Dybał – Life insurance 1. Premature Death  The death of a family head with outstanding unfulfilled financial obligations can cause serious financial problems for the surviving family members:: members     The deceased’s future earnings are lost forever; forever; Additional expenses are incurred, e.g., funeral expenses, uninsured medical bills, and estate settlement costs; costs; Some families will experience a reduction in their standard of living; living; Noneconomic costs are incurred, e.g., grief. grief. 3 1 Mariusz Dybał – Life insurance 1. Premature Death  Life expectancy has increased significantly over the past century: century:    Thus, the economic problem of premature death has declined;; declined However, millions millions of people still die annually from heart disease, cancer and stroke; stroke; The purchase of life insurance is financially justified if the insured has earned income and others are dependent on those earnings for financial support. support. 4 2. Financial Impact of Premature Death on Different Types of Families  The need for life insurance varies across family types: Mariusz Dybał – Life insurance  Single person: person:   SingleSingle-parent family family::    This group does not need large amounts of life insurance because premature death of single people with no dependants to support or other financial obligations is not likely to create a financial problem for others; The need for large amounts of life insurance on the family head is great because premature death of the single parent can cause great economic insecurity for the surviving children; Nevertheless, many of these families are simply too poor to purchase large amounts of insurance; Two income earners with children: children:  Both income earners need substantial amounts of life insurance because the death of one income earner can cause considerable economic insecurity for the surviving family members, because both incomes are necessary to maintain the family’s standard of living; 5 2. Financial Impact of Premature Death on Different Types of Families Mariusz Dybał – Life insurance  The need for life insurance varies across family types:  Traditional family: family:   Blended family: family:   The working parent in the labor force needs substantial amounts of life insurance because if the working spouse dies with an insufficient amount of life insurance, the family may have to adjust its standard of living downward; The need for life insurance on both family heads is great because both spouses are in labor force at the time of remarriage, and the death of one spouse may result in a reduction in the family’s standard of living; Sandwiched family: family:  A working spouse in a sandwiched family needs a substantial amount of life insurance because premature death of working spouse can result in the loss of financial support to both the surviving children and the aged parent(s). 6 2 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own Three approaches can be used to estimate the amount of life insurance to own:    The human life value approach; approach; Needs approach; Capital retention approach. 7 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own  The human life value approach: approach:   The amount needed depends on the insured’s human life value, which is the present value of the family’s share of the deceased breadwinner’s future earnings; earnings; To calculate:    Estimate the individual’s average annual earnings over his or her productive lifetime; lifetime; Deduct taxes, insurance premiums and selfself-maintenance costs costs;; Using a reasonable discount rate, determine the present value of the family’s share of earnings for the number of years until retirement. retirement. 8 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own  The needs approach: approach:   The amount needed depends on the financial needs that must be met if the family head should die; die; Important family needs must consider:      An estate clearance fund: cash needed for burial expenses, uninsured medical bills, and taxes; taxes; Income needed for the readjustment period, period, a 11-2 year period in which the family adjusts to its new living standard; standard; The dependency period is the period until the youngest child reaches age 18; 18; Life income to the surviving spouse, including income during and after the blackout period. The blackout period refers to the period from the time that Social Security survivor benefits terminate to the time the benefits are resumed; resumed; Families should also consider special needs, e.g., funds for college education and emergencies. emergencies. 9 3 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own Exhibit 1 How Much Life Insurance Do You Need? 10 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own  The capital retention approach: approach:  This approach preserves the capital needed to provide income to the family :   Income--producing assets are preserved for the heirs; Income heirs; To calculate:    Prepare a personal balance sheet; sheet; Determine the amount of incomeincome-producing capital; capital; Determine the amount of additional capital needed to meet the family needs. needs. 11 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own  Most families own an insufficient amount of life insurance:: insurance    About one in five households have no life insurance, insurance, Consumers delay delay,, and have difficulty in making correct decisions about the purchase of life insurance; insurance; Many families have only a limited amount of discretionary income: income:    The purchase of life insurance reduces the amount of discretionary income available for other needs, needs, Many families are in debt and have little savings, savings, After payment of high priority expenses, such as a mortgage, food and utilities, many families have only a limited amount of income to purchase life insurance. insurance. 12 4 Mariusz Dybał – Life insurance 4. Types of Life Insurance Life insurance policies can be classified in two general categories:     Term insurance provide temporary protection, protection, CashCash-value life insurance has a savings component and builds cash values values,, There are many variations of both types available today. today. 13 Mariusz Dybał – Life insurance 4. Types of Life Insurance Under a term insurance policy, protection is temporary: temporary:    Protection expires at the end of the policy period, unless renewed;; renewed Most term policies are renewable for additional periods: periods:   Premiums increase at each renewal; renewal; Most term policies are convertible, convertible, which means the policy can be exchanged for a cashcash-value policy without evidence of insurability:: insurability   Under the attainedattained-age method, method, the premium charged for the new policy is based on the insured’s attained age at the time of conversion, conversion, Under the originaloriginal-age method method,, the premium charged for the new policy is based on the insured's original age when the term insurance was first purchased.. purchased 14 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Types of term insurance:       Yearly--renewable term insurance is issued for a oneYearly one-year period, period, Term insurance can also be issued for 5 or more years, years, A term to age 65 policy provides protection to age 65, at which time the policy expires, expires, Under a decreasing term insurance policy, the face value gradually declines each year, year, Under a reentry term insurance policy, renewal premiums are based on select (lower) mortality rates if the insured can periodically demonstrate acceptable evidence of insurability (i.e., good health), health), Under a return of premiums term, term, the premiums are refunded if the policyowner outlives the term of the policy. policy. 15 5 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Term insurance is appropriate when:     The amount of income that can be spent on life insurance is limited, limited, The need for protection is temporary, temporary, The insured wants to guarantee future insurability; insurability; However,   Term insurance premiums increase with age at an increasing rate and eventually reach prohibitive levels, levels, Term insurance is inappropriate if you wish to save money for a specific need. need. 16 Mariusz Dybał – Life insurance 3. Amount of Life Insurance to Own Exhibit 2 Examples of Term Life Insurance Premiums 17 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Whole life insurance is a cash value policy that provides lifetime protection: protection:   A stated amount is paid to a designated beneficiary when the insured dies, regardless of when the death occurs, occurs, Types include:  Ordinary life, life,  Limited-payment life Limitedlife,, Endowment insurance, insurance, Variable life, life, Universal life, life, Variable universal life, life, Current assumption whole life, life, Indeterminate--premium whole life. Indeterminate life.       18 6 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Ordinary life insurance is a levellevel-premium policy that provides lifetime protection: protection:  Premiums are level throughout the premium paying period, period,  An ordinary life policy is appropriate when lifetime protection is needed, needed,  The major limitation of ordinary life insurance is that some people are still underinsured after the policy is purchased: purchased:  A term policy for the same premium would purchase substantially more protection. protection. 19 Mariusz Dybał – Life insurance 4. Types of Life Insurance   Under a limited limited--payment life insurance policy, the insured has lifetime protection, and premiums are level, but they are paid only for a certain period; period; Endowment insurance pays the face amount of insurance if the insured dies within a specified period. If the insured is still alive at the end of the period, the face amount is paid to the policyholder. policyholder. 20 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Variable life insurance is a fixedfixed-premium policy in which the death benefit and cash values vary according to the investment experience of a separate account maintained by the insurer: insurer:   The premium is level, level, The entire reserve is held in a separate account and is invested in common stocks or other investments: investments:  If the investment experience is favorable, the face amount of insurance is increased. increased. 21 7 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Universal Life Insurance is a flexible premium policy that provides lifetime protection: protection:   After the first premium, the policyholder decides the amount and frequency of payments, payments, Universal life provides considerable flexibility: flexibility:  Cash withdrawals are permitted. permitted. 22 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Variable universal life is an important variation of whole life insurance: insurance:   Most are sold as investments, investments, Similar to universal life except that:    The policy owner decides how the premiums are invested, invested, The policy does not guarantee a minimum interest rate or minimum cash value; value; These policies have relatively high expense charges, including frontfront-end loads for sales commissions, back back-end surrender charges, and investment management fees. fees. 23 Mariusz Dybał – Life insurance 4. Types of Life Insurance  Current assumption whole life insurance is a nonparticipating whole life policy in which the cash values are based on the insurer’s current mortality, investment, and expense experience. experience. 24 8 Mariusz Dybał – Life insurance 4. Types of Life Insurance Exhibit 3 Comparison of Major Life Insurance Contracts 25 Mariusz Dybał – Life insurance 4. Types of Life Insurance  An indeterminate indeterminate--premium whole life policy is a generic name for a nonparticipating policy that permits the insurer to adjust premiums based on anticipated future experience: experience:   After an initial guaranteed period, the insurer can increase premiums up to the maximum limit if the insurer’s experience is expected to worsen; worsen; A modified life policy is a whole life policy in which premiums are lower for the first three to five years and higher thereafter. thereafter. 26 Mariusz Dybał – Life insurance 4. Types of Life Insurance   Preferred risk policies are sold at lower rates to individuals whose mortality experience is expected to be lower than average (e.g., a nonnon-smoker) smoker);; Second--toSecond to-die life insurance insures two or more lives and pays the death benefit upon the death of the second or last insured: insured:  Usually whole life, but can be term. term. 27 9 Mariusz Dybał – Life insurance 4. Types of Life Insurance    Savings Bank Life Insurance (SBLI) is a type of life insurance that is sold by savings banks; banks; Historically, industrial life insurance was a class of life insurance that was issued in small amounts and an agent of the company collected the premiums at the insured’s home; home; Group life insurance provides life insurance on a group of people in a single master contract. contract. 28 Mariusz Dybał – Life insurance 5. Case application no. 7 Sharon, age 28, is a single parent who earns $30,000 annually as a secretary at a local  university. She is the sole support of her son, age 3. Sharon is concerned about the university. financial well well--being of her son if she should die die.. Although she finds it difficult to save save,, she would like to start a savings program to send her son to college. She is currently renting an apartment but would like to own a home someday. someday. A friend has told her that life insurance might be useful in her present situation. situation. Sharon knows nothing about life insurance, and the amount of income available for life insurance is limited. Assume you are a financial planner who is asked to make recommendations concerning the type of life insurance that Sharon should buy. The following types of life insurance policies are available:: available FifeFife-year renewable and convertible term, LifeLife-paidpaid-upup-at at--age 65, Ordinary life insurance,  Universal insurance. Which of these policies would best meet the need for protection of Sharon’s son if she should die prematurely?? Explain your answer; prematurely answer; Which of these policies best meets the need to accumulate a college fund for Sharon’s son? Explain your answer; answer; Which of these policies best meets the need to accumulate money for a down payment on a home? home? Explain your answer; answer; What major obstacle does Sharon face if she tries to meet all of her financial needs by purchasing cashcash-value life insurance? Sharon decides to purchase the fivefive-year term policy in the amount of $30,000. The policy has no cash value. value. Identify a basic characteristic of a typical term insurance policy that would help Sharon accumulate a fund for retirement retirement..    1. 2. 3. 4. 5. 29 Mariusz Dybał – Life insurance Thank You ;) 30 10 ...
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